Hedging Currencies

Beginner Questions
1

Hello guys. I am currently working on a portfolio that focuses solely on hedging currencies so that I can earn as much interest as possible per day but still have a positive portfolio at the end of the day. These trades will all be carried.

I’m on the fence between going for more interest by spreading out trades e.i. having six carry trades open or just sticking with a simple 2 currency hedge.

My friend has a model that risks 19K and makes a daily return of $40 a day by carrying only the highest yielding currencies. The flaw in his model is that all of the currencies are losing at the moment and his Net Asset Value is negative. My goal is to risk around the same amount of money but always retain a positive NAV.

Here’s what i mean. On my Oanda Practice account, I chose to Long the AUD/JPY, Short the AUD/USD, Long the CHF/JPY, Short the EUR/JPY, Long the NZD/JPY, Long the TRY/JPY, and lastly Short the USD/TRY. I placed the majority of these trades a few days ago and so far I am quite pleased with the results.
Before adding in my EUR/JPY short and my CHF/JPY Long (added those two yesterday, all other trades where placed last Thursday or Friday) I was risking 13k making only $15 a day in interest. The reason I added in the previous two trades was to get close to 19k to see what kind of interest I am making per day using 18.7k while taking on negative interest as well. Each trade has 50k units except for the AUD/USD which has 100k Units. So, at the time of writing I have used a total of 400k units and my unrealized p&l is sitting right at $700. It was up from 300 yesterday. The reason I put 100k in the AUD/USD is because if all my other positive interest carries are negative, I’m hoping the the AUD/USD and the other negative interest bearing carries will pick up the slack and keep my portfolio at dead even if not keep my portfolio positive. The reason I am taking this approach is due to the fact that If i ever decided to close out of all positions, I will always be net positive no matter what due to the interest i will incur prior to closing all of my positions. What the positions do does not matter, any extra money the trades make will only be an added bonus, but I am carefully developing a strategy that will give me a greater chance of making additional money other than interest to make these carries more worthwhile and allow me to risk more margin safely.

Ok. That was my first practice account, my real account I am hedging (this is not technically hedging per say but rather i am trading two correlative currencies opposite one another) the USD/CHF Long and the ZAR/JPY Short. So far these trades are doing fantastic as well. Interest on this account is much less than my practice account due to the fact that i don’t have 19k lol. I will note that the USD/CHF moves faster than the ZAR/JPY which could be an issue in the future. Which is why i am asking which approach is better. Two currencies or more than two with less money in each trade?

Also, Should I only stick to slower moving currencies or is there a good balance that can be achieved by mixing the right amount of slower moving and faster moving? From what I read in a book Hedge Fund managers first start by picking a stock that they expect to rise faster but fall slower than the market and long that stock. Then they pick a stock that they expect to fall faster but rise slower than the market and they short that stock. I’m applying this to the currency market but there is a big difference due to the fact that I’m solely going for interest. So I’m trying to pick the highest interest bearing currencies to have a long position in, but I’m also going against interest and longing or shorting currency pairs that will take interest. It’s important that I can make sure that I am net positive interest per day, and cam keep my account balance above or at zero so that if for whatever reason I had to close all the carries, I wouldn’t lose any money therefore avoiding risk as much as possible and turn a profit while doing so.

I’m still experimenting with which pairs i want to carry and have another practice account that has a different setup. All three accounts are positive and all three accounts make interest every day. The question is, long term which approach is going to be safer and more stable. If you would like me to post the other setup let me know. I greatly appreciate the time you guys took to read this and look forward to any advice that might point me in what to look for when choosing which currencies to hedge as soon as i open a new account with proper funding. This new account will probably only start with 2k but I will constantly be adding to it. I want to be able to risk at least 1600 of the original 2k but I want to do it by hedging and limiting overall risk as much as I possibly can through the right hedging techniques. Thanks again for the time and i can’t wait to get some professional advice!

2

The long AUD/JPY and short AUD/USD cancel out the AUD position, which is the long you want from a carry perspective (presumably), leaving you effectively long USD/JPY. Likewise, going long CHF/JPY and short EUR/JPY cancels out the JPY, which is the cheap “funding” currency leaving you effectively short EUR/CHF.

What you’re doing with all these positions is creating massive inefficiencies. You have to realize there’s a spread involved in carry interest rates, and it’s not a small one. If you go long AUD, for example, and then offset with a short somewhere else you’re going to end up negative on the carry because of the spread, not neutral.

I placed the majority of these trades a few days ago and so far I am quite pleased with the results.
Before adding in my EUR/JPY short and my CHF/JPY Long (added those two yesterday, all other trades where placed last Thursday or Friday) I was risking 13k making only $15 a day in interest.

How are you defining risking 13k?

Ok. That was my first practice account, my real account I am hedging (this is not technically hedging per say but rather i am trading two correlative currencies opposite one another) the USD/CHF Long and the ZAR/JPY Short. So far these trades are doing fantastic as well. Interest on this account is much less than my practice account due to the fact that i don’t have 19k lol. I will note that the USD/CHF moves faster than the ZAR/JPY which could be an issue in the future. Which is why i am asking which approach is better. Two currencies or more than two with less money in each trade?

The reason you’re doing well on those two positions is that you have a double long exposure to currencies which do well when the markets go risk-off, as they have done. Those positions are correlated.

It’s important that I can make sure that I am net positive interest per day, but also keep my account balance above or below zero so that if for whatever reason I had to close my trades I wouldn’t lose any money therefore avoiding risk altogether.

If you have any exposure at all to any given currency you have directional risk. You cannot avoid it. As the old saying goes, there’s no free lunch. You can’t get positive interest with no directional risk (but you can get negative interest!)

3

I want to address these three points. For the first one, I was only using 13k total to fund the positions i was in. I am currently risking 18.7k with the last two positions i added as previously mentioned.

Now the second point. So your saying I’m only doing well in my real account because I am trading two correlative currencies that only do well when risk aversion is the primary theme in the market? So, are these two positions stable enough to hold onto for a long term carry? Or do i need to re-access my approach?

As far as the last statement goes you mean to say that I can not properly hedge an account without incurring negative interest?

Lastly I would like to ask… So there is no way for me to carry, incur interest, and offset the trades so that my nav primarily stays above nuetral? If I am to incur interest and carry a trade it’s expected the carry trade will go down over time even though it provides interest on a day to day basis. The reason for this post is to find a way to incur interest, carry the trades, and have a nav that remains positive or neutral. Is this not possible? I would love to develop a system that exploits the inefficiencies of the market, not creates massive amounts of them.

How can I make this system more efficient? And I don’t understand how the spread would make me lose interest. As long as I have more interest bearing trades and less interest taking trades then shouldn’t I overall be net positive? The goal is to set up these trades to remain open for forever so to speak. I’m going to slowly add more positions in the same currencies as I gain more interest. maybe close out of a few after they hit some take profits but always leave one position open to help balance the account

4

Basically correct. The two trades are doing well because they have a correlated underlying driver of the USD and JPY benefiting from risk aversion. I would expect those positions to do poorly (at least in current market conditions) if the market became more risk accepting.

The reason for this post is to find a way to incur interest, carry the trades, and have a nav that remains positive or neutral. Is this not possible? I would love to develop a system that exploits the inefficiencies of the market, not creates massive amounts of them.

There is only one way to ensure an interest gain with no risk of taking a loss on a contrary exchange rate move. That is to take a position in the spot and an opposing position in a forward or futures contract. That will lock in an interest carry, but the forward/futures rate will be such that the interest you receive will be no better than about what you’d get by putting your money in a domestic sovereign debt instrument (like T-Bills) of the same maturity. Actually, you could probably replicate that kind of position with options, but you still would end up with a similar rate or return.

You cannot do anything with spot positions which allows you to benefit from interest rate differentials without having an exposure to exchange rate movements. No free lunch.

5

Thanks for the info. I understand that the market Is going to move against me. I want to be able to minimize directional movement by calling the direction in both ways but have it split between different but correlative currency pairs. Is there anything I can do to ensure interest at a rate in which the interest over time outweighs the paper loss I may incur while holding onto the trade for that period of time? I figured hedging would work, but I either do not understand how to hedge correctly or It’s near impossible to eliminate the majority of the risk while still making a profit whether it be in interest or the trades themselves.

I have come up with another approach that I deem possible.

Interest occurs once per day at 4 oclock eastern time. I have noticed that I have to be in the trade at least until the interest hits my account. So if i get into a currency that is going to give me interest right before 4 oclock and am able to close out of it profitable at 4:30… would this approach involve less risk? I would only get into a currency that has a higher probability of continuing in the direction of positive interest but would want to immediately close it or put a trailing stop that would at least cover the spread after interest has been received. The only problem i see with this approach is that i am subject to lose trades because I will be entering one or two trades per day…and in order to be profitable I would have to make enough winning trades over time for it to be worthwhile while gaining interest altogether.

6

I have been trying to come up with a good system that takes advantage of interest for years. I have not been successful yet. You have to hold trades for a long time just to gain your spread back. So opening and closing trades every day or week will not gain any interest profit.
You can just hedge in the direction that will give you highest interest. But your gain will be small. eg only buy AUDUSD.

che3ck out this thread
http://forums.babypips.com/expert-advisors-automated-trading/42898-advanced-hedger.html

Reason being I have tried this system on a number of pairs and GBPUSD, USDCHF, USDCAD, AUDUSD are the most stable hedged pairs. It is really GBPUSD,USDCHF hedged and USDCAD, AUDUSD hedged.
I am not saying you should use that system, just in regards to best pairs over last 6 months.

7

Thanks for the info goldylox. I understand that carry trading does not involve closing out of the trades etc. I just want to be able to close out of the trades in profit if I ever needed too.

The first example I talked about on my practice account is doing pretty well. I previously posted it was up $700 now it’s up $1,100 and this is only half a day later. I’m going to hold onto these trades in my practice account for the rest of the year and take note of the NAV each day. If the currencies I’m currently hedging provides some decent profit as well as interest, I’m going to follow this model with my real account.

I like the EA idea but would rather not open and close the trades.

By closing the positions you are losing an advantage that may have taken days to form.

For example, the AUD/JPY trade listed in my first post is up 180+ pips at the moment. If I close out of this position, I will have over 1.1k in profit (it’s a 50k unit trade). But if I close out of the position, I then will lose the advantage of being 180 pips away from zero. It could take days, or even weeks for me to lose all 180 pips that has taken only 4 days to gain. In the meantime I’m generating positive interest daily on the appreciated 50k units, my NAV remains well above neutral and if I wanted to make a quick 1k plus, I can close out of the position before it goes below 150 pips if I wanted too but why give away an edge? Like previously mentioned, I don’t care how the trades do as long as I’m generating net positive interest and the sum total of all the trades are either positive or neutral worst case scenario. To enter a group of trades that constantly make money and can literally remain open until the day you die would be a dream for most of us. Not to mention there is hardly any commission to the unlimited upside if hedged properly.

8

In short, no. In order to take advantage of the yield differential in a carry trade situation you have to be exposed to exchange rate risk. Exchange rate moves can completely blow away interest income in a very short period of time. The hedges you are looking to do just create different exchange rate exposures. By the I mean say you are long EUR/USD and want to hedge that exposure by going short EUR/GBP. While that action would reduce or eliminate your exposure to EUR movements, you would now have a long GBP/USD exposure in your account. So long as you have some directional exposure you are subject to losses in your positions, and potentially big ones.

Taking AUD/JPY as an example, in the last three months that rate has seen a drop of more than 15%. This is multiples of what you could have made in positive interest carry, and if you were leveraged at even 4:1 you would have gotten margin called right out of the trade for a 50% loss on your account.

I have come up with another approach that I deem possible.

Interest occurs once per day at 4 oclock eastern time. I have noticed that I have to be in the trade at least until the interest hits my account.

Not if you’re trading with Oanda. You will have 4pm ET interest payments, but you’ll also have them when you close the position.

So if i get into a currency that is going to give me interest right before 4 oclock and am able to close out of it profitable at 4:30… would this approach involve less risk?

Less risk, but as goldylox noted, the spread will eat up your interest profits and you will be subject to adverse exchange rate moves.

The fact that you’re seeing these kinds of moves in your account equity are perfect examples of the exchange rate risk you have in your positions. If you were as hedged as you seem to be aiming for, you wouldn’t see those sorts of moves.

For example, the AUD/JPY trade listed in my first post is up 180+ pips at the moment. If I close out of this position, I will have over 1.1k in profit (it’s a 50k unit trade). But if I close out of the position, I then will lose the advantage of being 180 pips away from zero. It could take days, or even weeks for me to lose all 180 pips that has taken only 4 days to gain.

There is an error in your thinking here. Forex is a mark-to-market environment. That 1.1k in profit is already in your account. You don’t have to close a trade to have a gain or loss recognized.

9

So your saying the 1.7k my practice account is up is already part of my account balance? I could technically withdraw that without closing the carries if it where real money? And yes I understand I’m subject to risk no matter how you slice it. I watched the AUD/JPY drop 15% this year. If you think about it like a stock, it’s undervalued. Most of the currencies I chose to “hedge” are slower moving and undervalued. The practice account has stably gone up each day by a few hundred but I’m only making 12$ in interest. I must be doing something right or I wouldn’t be making stable gains as well as acquiring a far amount of interest. If I wanted to I could place stops on each of these trades to ensure some profit but like I said I want to see how these trades do for a few months

10

There may be some brokers who restrict you from doing so (which they really shouldn’t), but otherwise since it [I]is[/I] real money, yes. You just can’t take out so much that you can’t cover your margin requirements.

And yes I understand I’m subject to risk no matter how you slice it. I watched the AUD/JPY drop 15% this year. If you think about it like a stock, it’s undervalued.

You cannot think of exchange rates like stocks. They are entirely different animals.

Most of the currencies I chose to “hedge” are slower moving and undervalued.

  1. How are you defining undervalued?
  2. Slower moving currency pairs tend not to be the pairs with the type of interest rate spreads you want to use for earning interest.

The practice account has stably gone up each day by a few hundred but I’m only making 12$ in interest. I must be doing something right or I wouldn’t be making stable gains as well as acquiring a far amount of interest. If I wanted to I could place stops on each of these trades to ensure some profit but like I said I want to see how these trades do for a few months

You are seeing profits on the positions because the exchange rates are moving in your favor. You say you’re up 1700 in the account, but only 12/day is coming from interest. That means most of the gain is from the moves in exchange rates which have been driven the last few sessions by the market going more risk-on. If you see it shift back to risk-off you’ll see those gains wiped out very quickly, and potentially turned into losses. I’m not saying that [I]will[/I] happen. I’m just saying it’s a risk so long as you have that kind of exposure.

People try to come up with all kinds of strategies which rely on narrow exchange rate moves. They were all over the place in the middle 2000s because for a few years they did well because of very low market volatility. Then, in 2007, they all blew up because suddenly the ranges broke and the markets went on trends that more than wiped out all the gains made during ranging periods.

11

Yes the majority of the gains are coming from the trades themselves and not the interest. But the farther I get away from zero in the positive direction, the longer i can carry these trades and keep making 12$ a day. The moment my nav gets close enough to touch zero I’m going to close all of these carries therefore eliminating all risk. I will have made a few hundred in interest at that point.

Slower moving currencies are the ones that give the highest interest. Take TRY/JPY for example, it has the highest differential to date. That is why I choose the TRY and the ZAR etc. If they each are up over 200 pips… It would take a serious fall to wipe out all of those gains in one day, at that point my AUD/USD will pick up the slack

12

That sounds fine and good, but what happens when you’ve closed the trade down and look to re-open to restart the process (or start it in a live account)? What if the market moves straight against you?

Slower moving currencies are the ones that give the highest interest.

Compare TRY/JPY over the last 3 years to EUR/USD over the same time frame and tell me again how the higher yield differential equates to lower volatility/smaller moves.

13

Proper analysis is going to be the leading determinant to whether or not I will be able to follow this portfolio with my live account. If it appears that the market has a higher probability of going against me in 2 months time, then I will re-access which currencies to carry with my live account.

I agree with you that the TRY moved more than the euro, but it took longer to make such big moves. Take the ZAR/JPY for example. I’m only up 30-40 pips and I’ve carried it for a week. So at best I might be up 120 pips after a months time. If the timing is right I can hopefully reduce my exposure to such big moves by carrying other currencies that are likely to pick up the potential loss.

If you where to try and develop a portfolio that’s going for a long term carry approach what currencies would you include and why? Instead of constructive criticism, I would like to read how you would run such a portfolio. Thanks for the pointers

14

You absolutely cannot extrapolate what happens in a week’s worth of trading into what could happen in an exchange rate (and by extension a position) that you plan on holding as long as you can get away with. You need to be looking back years to see the kind of price moves the market(s) you are looking to trade go through.

If the timing is right I can hopefully reduce my exposure to such big moves by carrying other currencies that are likely to pick up the potential loss.

And there you get to the crux of the issue -[I] if you get your timing right[/I]. As long as you have an exposure to any exchange rate (which as I’ve noted you always will in some fashion) your timing of entries and exits will have a bigger long-run influence on your profitability than the interest you earn along the way.

If you where to try and develop a portfolio that’s going for a long term carry approach what currencies would you include and why? Instead of constructive criticism, I would like to read how you would run such a portfolio. Thanks for the pointers

I’m not sure how offering suggestions about developing a portfolio isn’t constructive criticism, but whatever.

Since there is no way to play for interest income (at least not in excess of what you’d get putting your money in sovereign debt) without exchange rate exposure, any strategy you use must have a system for timing your entries and exits. For example, you could have an approach which only goes long AUD/JPY (or whatever high rate differntial pair you favor) when certain bullish conditions are met such that you get both the interest income and the exchange rate appreciation. As I noted, though, these carry trade positions can be very volatile (relatively speaking) as they are subject to risk aversion reversals, so risk management is important.

15

The more I read what you write, the more I feel like what I’m trying to do is impossible. It seems like I need to either day trade or give up on long term carries be because you stressed that big fluctuations occur in the currencies that generate good interest. I understand a weeks time means nothing. That’s why I said I want to hold onto these carries for months on my practice.

Anyways I appreciate your advice. I meant build a portfolio that I could run long term instead of tearing mine apart when I said constructive criticism. But disregard that. I understand that you are just trying to help and now I know where you are coming from.

Might I ask you how well do you day trader? What strategy do you use if you do not mind sharing?

16

I very rarely day trade. I spend my day writing about the markets (I’m a professional analyst) and it’s hard to retain a good focus on that (and my other duties) while also actively trading short-term positions like that.

17

Well it’s awesome that I was able to get the opinion of a professional analyst! I was considering going into the field myself… I’m better at long term trading than short term any day.

On a side note, I cut the losses to my practice account and added a long EUR/USD and a long AUD/USD. So my practice is up 8k :slight_smile: much better than the 2k with losing trades yesterday. Risk aversion must be on a back burner for all of these high yielding currencies to be trending up for a straight week.

So I take it that you do not trade often rhody trader?

18

It seems to go in bursts based on what I’ve got on my plate. I don’t like to trade when distracted. And I don’t just trade forex.

19

Did going to school help you become a better trader? I have noticed the bursts of ‘consumer’ confidence as well. I’m going to split up my exposure to not just the forex market, but possibly the stock market. I’m only 21
But my goal is to retire at 30-35. I’m saving as much as I can, but I understand that without having any money in the market, there is less chance my money can grow at a fractionally faster rate than just in a typical savings account. I have also considered putting money in foreign bank accounts but I still have some research to do on that aspect.

20

I did study finance in school, but I was already well into my trading education by then, so it likely had little impact.

And note that I said my trading tends to come in bursts when I’m not distracted, not that I have bursts of confidence. If your confidence is coming in bursts then it suggests there’s something in need of addressing.