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Risk Reward for Carry Trade

  • #1
  • First Post: Mar 13, 2007 8:27pm Mar 13, 2007 8:27pm
Greeting all,

I have a question concerning the risk reward ratio for carry trades. In my normal forex trades I try to use risk reward ratio of at least 1:1 in terms of pips. My question is should I do this for my carry trades also? For example, would it be wise to risk $1000 to gain $700 in interest in a year’s time. My stop loss would be set to a place where I would lose $1000 if my carry trade is stopped out. Is it wise to even use a stop loss in carry trades?

Also it seems that the potential for my profit could be much greater if I held the trade for longer, say two or even three years. This would affect my risk reward ratio.
  • #2
  • Mar 13, 2007 8:39pm Mar 13, 2007 8:39pm
The catch-up period for the Carry Trade will greatly depend on how far the Yen drops. Right now, the RR is pretty low...since we're still very high above the lowest low. If you hold long term, the break-even period with interest may be a few years. This means that even though you could hold for many years, IF the maximum low is hit, you would be looking at a break-even date of almost 10 years...AT the CURRENT interest rates. Should the interest rates converge, your interest will be even less.

Carry trades should be carefully planned in conjunction with the interest rate cycles. The long-term (2-3 year outlook) for the dollar / yen and pound /yen are looking less productive as both the FOMC and BoE are expected to at best case hold rates and worst case ease rates while the yen does the opposite.

The only redeeming factor is Oil...as Oil goes up, it is expected that the Yen SHOULD go down...however, there is no guarantee of this affecting the price enough.

Think about it this way...If you expect the price of the yen to fluctuate at least 1000 pips, then if you were to simply buy and hold, you'd be looking at a 3 year break-even period.

Now, you may dollar cost average, but like I said, there is an expectation that at least in the US, rates will ease as we head towards a recession. Should this happen, the interest rates will converge, and the break-even period will be pushed back.

In my opinion, carry trades should be almost technically based on pull-backs of decent size and held for short periods of time (not held for years).

Good luck.

Quoting Crestwind
Greeting all,

I have a question concerning the risk reward ratio for carry trades. In my normal forex trades I try to use risk reward ratio of at least 1:1 in terms of pips. My question is should I do this for my carry trades also? For example, would it be wise to risk $1000 to gain $700 in interest in a year’s time. My stop loss would be set to a place where I would lose $1000 if my carry trade is stopped out. Is it wise to even use a stop loss in carry trades?

Also it seems that the potential for my profit could be much greater if I held the trade for longer, say two or even three years. This would affect my risk reward ratio.
  • #3
  • Mar 13, 2007 8:52pm Mar 13, 2007 8:52pm
Quoting mrmikal

In my opinion, carry trades should be almost technically based on pull-backs of decent size and held for short periods of time (not held for years).

Good luck.
I agree with this. I would/do use 4hr charts and only take long positions on pairs such as AUD/JPY and GBP/JPY. These are the pairs I use to "carry". Though it isnt blind carrying of a trade, you can gain the advantage of the trend and the interest. I have considered using daily charts, though with the system I use.. it wouldnt be appropriate at the current time. Do some technical analysis and only trade LONG.
The market is my nation. Traders, my family. Hello, brothers and sisters!
  • #4
  • Mar 14, 2007 6:03am Mar 14, 2007 6:03am
Quoting mrmikal
The catch-up period for the Carry Trade will greatly depend on how far the Yen drops. Right now, the RR is pretty low...since we're still very high above the lowest low. If you hold long term, the break-even period with interest may be a few years. This means that even though you could hold for many years, IF the maximum low is hit, you would be looking at a break-even date of almost 10 years...AT the CURRENT interest rates. Should the interest rates converge, your interest will be even less.

Carry trades should be carefully planned in conjunction with the interest rate cycles. The long-term (2-3 year outlook) for the dollar / yen and pound /yen are looking less productive as both the FOMC and BoE are expected to at best case hold rates and worst case ease rates while the yen does the opposite.

The only redeeming factor is Oil...as Oil goes up, it is expected that the Yen SHOULD go down...however, there is no guarantee of this affecting the price enough.

Think about it this way...If you expect the price of the yen to fluctuate at least 1000 pips, then if you were to simply buy and hold, you'd be looking at a 3 year break-even period.

Now, you may dollar cost average, but like I said, there is an expectation that at least in the US, rates will ease as we head towards a recession. Should this happen, the interest rates will converge, and the break-even period will be pushed back.

In my opinion, carry trades should be almost technically based on pull-backs of decent size and held for short periods of time (not held for years).

Good luck.
mrmikal explained some nice points above; I'd like to add something to it:

We should also consider one dreaded factor in the long term scenario - Broker longevity.

If a carry trade went awry needing more than a year to break even, you should also worry if the broker would last this long also.
  • #5
  • Mar 14, 2007 6:49am Mar 14, 2007 6:49am
Quoting BurgerKing
mrmikal explained some nice points above; I'd like to add something to it:

We should also consider one dreaded factor in the long term scenario - Broker longevity.

If a carry trade went awry needing more than a year to break even, you should also worry if the broker would last this long also.
ROFL! That is a bleak view on things.

Boy, if a broker cant be trusted to make it through a year.... sheesh.
The market is my nation. Traders, my family. Hello, brothers and sisters!
  • #6
  • Mar 14, 2007 11:10am Mar 14, 2007 11:10am
So are you guys saying that most people don’t hold their carry trade for long periods of time?

Do most traders even use a stop with their carry trades?
  • #7
  • Mar 14, 2007 11:34am Mar 14, 2007 11:34am
Crestwind, I'm not sure you understand the true purpose of the carry trade.

The carry trade is simply a loan in one currency that's expected to keep rates low (and thus have a WEAKENING currency) while investing in a higher yield currency to take advantage of cheap money with the expectation that the higher yielding investments will grow.

That is the fundamental purpose of the carry trade...the interest earned on the carry is only icing, so to speak. It shouldn't be the only profit from the carry trade...otherwise, you're looking at a lame ROI.

A carry trade, operates under the principle that the base currency is expected to strengthen while the low yielding cross is expected to weaken. This gives you a fundamental reason for being in the trade. That's why the current carry trade has been in play for a while now, the expectation was that high yielders (GBP, AUD and even the USD) were expecting to raise rates through the carry trade (which they did) while the crosses (JPY and the CHF) were expected to keep yields low as their economies were in slow recovery. This made the plays fundamentally attractive at certain prices, and fueled the weakening in the yen and strengthening in those base currencies.

Now that the roles are flipping, the carry trade doesn't carry enough potential to offset the risk (being a 600-1500 pip drop in some currencies over a short period of time while not being able to recover enough fast enough to offset the drop).

Quoting Crestwind
So are you guys saying that most people don’t hold their carry trade for long periods of time?

Do most traders even use a stop with their carry trades?
  • #8
  • Mar 14, 2007 12:18pm Mar 14, 2007 12:18pm
Quoting Crestwind
So are you guys saying that most people don’t hold their carry trade for long periods of time?

Do most traders even use a stop with their carry trades?
No. People do carry for long periods of time. I know an individual that has held gbp/jpy since late 2005. Didn't once take it out. He earned more in interest than I have ever earned over the course of a year... not to mention thousands upon thousands of pips. However, what I am taking into consideration is the behavior of the market at the given point. Too bad for use we were not around in 2002, 2003, 2004, 2005 even last year in 2006 when the carry pairs were booming. The JPY is clearly stronger now than it has been since 2003. Also, we are seeing levels that we have not seen since 1998.. after which the market went from 240-150 for the G/J.

I suppose what I am saying is that given the market volatility, setting up a position that will be able to survive no more than a 500-1000 pip drawdown may not be the best thing. It would be better to wait for some good signals, go LONG only and see how the market turns out. This is only my opinion and presently how I trade.

EDIT: If you were to earn about $700 in interest, your draw down would be about 205.00 before you were margin called I do believe. Perhaps we dont see this level for 5 years, perhaps we see it 3 weeks from now. I was told by the same guy that was carrying that position in the main post that he expected a 109.00 $/JPY. He is no longer in his GBP/JPY. I don't know.
The market is my nation. Traders, my family. Hello, brothers and sisters!
  • #9
  • Mar 15, 2007 6:37pm Mar 15, 2007 6:37pm
Thank you mrmikal, StockKJay, and everyone else that responded. Your information has been helpful to me.
  • #10
  • Mar 19, 2007 2:05am Mar 19, 2007 2:05am
Thus far, I can only think of 3 possible Carry Trades:
Unhedged Carry Trade (ie, Long GBPJPY or Long USDJPY)
Full Hedged Carry Trade (ie Long GBPJPY and Short GBPJPY)
Partially Hedged (aka correlation hedged) CarryTrade (Long GBPJPY, Short CHFJPY)

What is the average / realistic return for a Carry Trade?

2% Monthly?
5% Monthly?
10% Monthly?
  • #11
  • Mar 19, 2007 2:41am Mar 19, 2007 2:41am
Quoting BurgerKing
Thus far, I can only think of 3 possible Carry Trades:
Unhedged Carry Trade (ie, Long GBPJPY or Long USDJPY)
Full Hedged Carry Trade (ie Long GBPJPY and Short GBPJPY)
Partially Hedged (aka correlation hedged) CarryTrade (Long GBPJPY, Short CHFJPY)

What is the average / realistic return for a Carry Trade?

2% Monthly?
5% Monthly?
10% Monthly?
Full hedge is 80% a year.
Mr. Trend
  • #12
  • Mar 19, 2007 3:01am Mar 19, 2007 3:01am
Quoting Mr Trend
Full hedge is 80% a year.

Full hedge Carry requires either (a) frequent rebalancing, or (b) fat accounts to withstand huge drawdowns.

I dont think fat accounts can achieve 80% annually:
GBPJPY moved from 240 to 220 in the last few months 2000 pips or about $17,000. This would entail about $20K on either side of the Carry.

$40K doing $26 daily = $9360 / $40000 = less than 25% annual return.

I dont know if smaller accounts can achieve 80% annually with frequent rebalancing. This is best performed by the well experienced.
  • #13
  • Last Post: Mar 19, 2007 5:39am Mar 19, 2007 5:39am
It depends on what currency you do the full hedge on. The G/J is not a good currency to do it because of it's volatility. But I can attest that you can acheive 60%+ APY on a full hedge.

I calculated my profit during the period of time I was able to do it to be just over 100% APY.

If you can plan well, you can cut down rebalancing by leaving about a third of the hedge in cash. Once your positions get out of whack by a percentage, you temporarily close a few positions on the winning side (or both) and the reopen when there is broker arbitrage. With good money management, I was able to keep my hedge over-maxed for almost 2 months without having to completely rebalance.

The problem is finding non-discriminatory swap free brokers.

Quoting BurgerKing
Full hedge Carry requires either (a) frequent rebalancing, or (b) fat accounts to withstand huge drawdowns.

I dont think fat accounts can achieve 80% annually:
GBPJPY moved from 240 to 220 in the last few months 2000 pips or about $17,000. This would entail about $20K on either side of the Carry.

$40K doing $26 daily = $9360 / $40000 = less than 25% annual return.

I dont know if smaller accounts can achieve 80% annually with frequent rebalancing. This is best performed by the well experienced.
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