Carry Traders Fight Back But Will They Survive in 2008?

Despite the recent easing on financial conditions the outlook for the carry trade strategy remains very bearish. Short term interbank lending rates remain well above government bond yields of similar maturity and the repeated injections of liquidity by the world’s most important central banks are failing to restore confidence in the global financial system. Last week, the DailyFX Dynamic Carry Trade Portfolio was down by 71 pips in capital but accumulated an additional $87 per basket on interest payments. The most lucrative trade was the position we held in the Australian dollar with 111 pips gain in capital appreciation plus $20 on interest payments accumulated along the last 5 days. Yet, all of those gains were offset by the losses in the long position we held in the Sterling against the U.S. dollar (-361 pips).

Additional Information

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

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.