This week the DailyFX Dynamic Carry Trade Basket lost 79 pips in capital, but this was largely offset by over $150 in interest received. The best performer in our basket was the USDCHF, as CHF weakness allowed for a bounce in the popular carry trade pair. Our largest decliner was the Australian dollar, as the AUDUSD brought 99 pips in capital losses. Uncertainty in risky assets across global financial markets led the Asia-Pacific currency lower, with relative dollar strength doing little to ease declines.
Volatility remains high across all currency pairs, which is almost always detrimental to carry trade performance. We will have to wait until markets show signs of stability to regain complete confidence in the interest rate-linked strategy. Yet a moderation in the implied volatilities of currency options suggests that markets may slow down excessive price movements through the medium term. Of course, a coming week of strong event risk leaves the short term fraught with key events that will drive large price moves across major currency pairs.
What Are We Currently Long?
AUD/USD
GBP/USD
USD/CHF
USD/HKD
USD/JPY
Implied volatility has showed signs of moderating through the short term, but it remains at multi-year highs on the critical USDJPY pair. Clearly we would hope that the barometer of expected volatility would moderate to previous lows seen through the strong USDJPY advances. Absent such an occurrence, we will stay on the defensive on our carry trade strategy.
Additional Information
In an ever changing world, making profitable carry trades* (definition below) are not as easy as they use to be. Therefore we have created a dynamic carry basket that changes when the monetary policy outlook for a central bank changes or if there is significant event risk ahead. Follow the performance of the DailyFX Dynamic Carry Trade Basket
What is Carry Trade
All that is needed to understand the carry trade concept is a basic knowledge of foreign exchange and interest rates differentials. Money shifts from around the world in seek of the highest yield and the benefit of trading currencies is that you are dealing with countries that have interest rates, which are charged or received every single day. If you are positioned on the side of positive carry, you have the right to earn that interest, which can be quite lucrative over time.
Protective Stop-Loss
Substantial gains made from interest rate differentials provide undeniable evidence that the carry trade strategy has been very successful over the past few years. Still, this strategy involves significant risks and an adequate protective stop is required. We are using a protective stop-loss equivalent to five times the average true range. Stop losses are activated when we have a weekly close below the specified stop level.
Position Sizing
Our position size varies according to each currency volatility. Generally, the more volatile the currency is, the fewer lots we trade. For example, let’s assume you have $10,000 and you are trading 10K lots, you decide to limit your risk per trade to 3% or $300 and the 90 days average true range for the EURUSD is 100 pips. In this case, if you go long EUR/USD you could buy 3 lots, since ($10000 * 3%) divided by (0.0100*10K) = 3 lots. In case the final result is not an integer you should always rounded it down to limit your exposure.
Written by David Rodriguez, Currency Analyst for DailyFX.com