Yesterday, we discussed about the main characteristics of carry trading strategies. Today we discuss about the actions a trader must follow to be successful with this strategy and the mistakes he has to avoid.
The first think to do is following the actions of central banks. Since carry trades depends on interest rates, a carry trader must always pay attention when a central bank takes its monetary policy decisions. A central bank can tighten or easing its monetary stance. When it tightens by hiking rates while another bank does the opposite, an opportunity for carry is created, assuming the country tightening its monetary policy has a higher-yielding currency to begin with. Therefore, a good strategy can be: going long on currencies before a central bank tightens its monetary policy and going short on those currencies whose central banks are easing the monetary stance.
The second thing to do is identifying the right financial and economic environment. For example, carry trades lost its appeal during the 2008 financial crisis, as liquidity dried up and investors avoided risks. Carry trade strategies are ideal when financial markets are calm and investors show an appetite for risk. The Japanese yen and Swiss franc are often referred to as “safe currencis”. But this is not always true. The yen and franc generally appreciate in value because the leveraged carry trades commonly funded by these currencies become unwound, not because of demand for these currencies themselves. Thus, calm, low-volatility financial environments generate carry trade opportunities.
As for the mistakes to avoid, a succesful carry trader must bear in mind that he has to approach theis strategy carefully and correlate with risk assets such as stocks and high-yield bonds more broadly. For example, though AUDCHF pair is commonly known as carry trade, it has lost money due to capital depreciation, because of it has been due to a down-cycle in commodities. Australia is a commodity-rich nation. Global commodities prices have fallen since mid-2014, before rebounding since their early-2016 bottom. The Reserve Bank of Australia (Australian central bank) has cut rates in order to tackle the downswing in growth and inflation.
When central banks cut rates investors move their capital elsewhere, looking for more profitable trading opportunities. When this selling is exacerbated through leveraged positions, gains can be reversed quickly. Indiscriminately going long a higher-yielding currency against a lower-yielding currency can generate losses. A trader must always be able to forecast how rates are likely to change in the future, by predicting future growth and inflation. The higher growth and inflation, the greater likelihood of rate hikes, ceteris paribus.
Let’s take an example. TRYCHF is a large spread currency pair. Suppose a trader is carry trading this exchange rate. If markets believe that the Turkish central bank is likely to ease its monetary stance relative to the Swiss central bank, this would lead to both diminished carry and capital depreciation. In the end, the profitability of the carry trade strategy declines. If we also think that traders often use leverage, even a relatively modest -5.0% fall in TRYCHF magnified by a 10:1 leverage will erase all the gains. This is why it is always important to properly managing risk.