Carry has wavered over the past week, but demand for yield seems to have held on strong. Over the past few weeks, traders have honed in on the Federal Reserve’s ongoing efforts to stabilize global credit markets and revive the market’s appetite for demand. Since the panic stirred up by the near collapse of Bear Stearns, policy officials have taken dramatic steps to fortify the foundations of the global financial markets.
The Fed cut its benchmark and discount rates 75bp, announced a larger boost of liquidity in the market and broadened its terms of acceptable collateral for the Term Auctions Facility loans. While there have been efforts made outside of the US to improve conditions, these policy changes have no doubt had the greatest impact on overall risk sentiment and in turn demand for yield and carry. So far, these building attempts to correct a deeply rooted problem have had mixed results. High yielding currencies have received a steady bid over the past week. On the other hand, the low-yielding Japanese yen and Swiss franc have similarly advanced with considerable strength. This has left the US dollar as one of the few viable short components in the currency spectrum with a low benchmark rate and dovish projections calling for even lower rates down the road.
Is Carry Trade a Buy or a Sell? Join the DailyFX Analysts in discussing the viability of the Carry Trade strategy in the DailyFX Forum.
[B]
Additional Information[/B]
Making profitable carry trades 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
[B]What is Carry Trade
[/B]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.
[B]Protective Stop-Loss[/B]
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.
[B]Position Sizing[/B]
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.
[I]To contact John about this or other articles he has authored, you can email him at <[email protected]>. [/I]