Forex Trading Ideas
There has been much written about the carry trade in the bond market during 2004 and early 2006. In its simplest form, an investor borrows on a short term basis at the federal funds rate (as low as 1.5% during 2004) and uses the borrowed funds to purchase 10 year treasury notes yielding 4.0%. The investor then captures the 2.5% difference between the two yields. The main risk to the investor is that if yields rise, the value of the 10 year treasury note would go down possibly erasing the monies made on the interest rate differential. In addition, the rate increase would shrink the yield captured.
In a currency carry trade, an investor borrows in a low interest rate currency, such as the Japanese yen (currently yielding 0.0%), and then takes a long position in a higher interest rate currency, such as the U.S. dollar (currently yielding 4.75%), betting that the exchange rate will not change so as to offset the interest rate differential. This can be accomplished by buying the USD/JPY pair. Each day, at about 5:00pm EST, the account holding that trade will be credited with daily interest reflecting the 4.75% difference in interest rates (currently about $13 per $100,000 position). Since the dollar has appreciated against the yen during 2005 and the interest rate differential persisted, that investment strategy has provided very profitable. The main funding currencies for the carry trade as of late have been the yen and the Swiss franc. The main recipients of the borrowed funds included U.S. dollar, the pound sterling and the Australian and New Zealand dollars, as well as a number of emerging market currencies. Some of the more significant carry trade opportunities are presented below.
As with the U.S. domestic bond carry trade, there are significant risks associated with a forex carry trade. Given the significant leverage available to forex traders, these risks are even greater. Of course, this added leverage also increases returns if the trade is successful. For example, assuming full utilization of 100:1 leverage (which is widely available), each $100,000 long position in the USD/JPY pair would produce a $4,750 annual return. Compared against a $2,000 margin deposit, this represents a 180% return. As you can see, even more conservative levels of leverage can still produce favorable returns. Of course, if the pair were to decline in value by more than 4.75% during the year, the decline in currency value would offset all of the carry return on the position. Moreover, if 60/40 capital gain treatment had been elected for the trade (see Taxation), the trader would be left with ordinary interest income (taxable at a 35% marginal income tax rate) and an offseting capital loss (which could not offset the interest income). Thus, there are additional economic risks to this trade beyond just risk of currency value changes. This risk of whipsaw might make a 60/40 capital gains identification and election imprudent here.
The risks associated with the carry trade can be most recently illustrated by the problems with the Icelandic Krona. Traditionally, one of the more exotic currencies purchased in a carry trade due to its high yield, in recent years, hedge funds and others borrowed large sums of money in places like Japan (where rates are near 0%), and invested the money in Iceland, where rates now stand at 11.5% (as of April 15, 2006). Unfortunately for carry traders, in recent weeks, Iceland's stock market has tumbled nearly 20% and the Icelandic Krona has collapsed (losing 20% of its value) as investors have withdrawn funds and unwound carry trades. In looking at Iceland's economy, its current account deficit (a broad measure of trade in goods and services plus certain financial transfers) is around 16% of GDP -- more than twice that of the U.S. In February of 2006, Fitch Ratings reduced its outlook for Iceland's government debt which caused the krona to fall 7% over two days.
Momentum – Trend Following
Some of the better known trend followers include John W. Henry. For those of you who do not know him, he is the current owner of the Boston Red Sox and founder of John W. Henry & Company, an alternative asset manager that is one of the largest managed futures advisors in the world. Trend following is based on the premise that one cannot predict anything, and that market prices, rather than market fundamentals, are the key pieces of information needed to make investment decisions. A trend follower therefore identifies and follows trends when making investment decisions. For example, if the USD/JPY has been trending higher for an identifiable period of time, a trend follower would purchase the pair and hold the investment until the trend was broken (and then would sell). As you might surmise, a market which is in a trading range (described below) does not facilitate trend following opportunities.
Traders which follow the macro pictures include such well known investors and advisors such as Warren Buffet (Chairman & CEO of Berkshire Hathaway), Jim Rogers (author of and former trader at Quantas Fund) and Pete Peterson (founder of the Blackstone Group). These traders, or more appropriately, investors take the view that the underlying fundamentals in a given market will eventually determine prices and one just needs to invest in accordance with the fundamentals. Warren Buffet's bearish or negative views on the long term value of the U.S. dollar is well known and represents a belief that fundamentally, the U.S. currency must fall in value due to the yawning federal trade and budget deficits and low U.S. savings rates. Mr. Buffet's annual letters to stockholders provide a wealth of knowledge on his views and his 2003 article in Fortune Magazine discussing his bearish view on the U.S. dollar is well read. Any fundamental trades should be made with long term time horizons (such as 6 months to 2 years or longer).
A trading range is a market where the currency pairs moves back and forth between high and low prices for an extended period of time. When these can be identified, the market can be bought at the low price and sold as it approaches the high price. Moreover, as the high price approaches, the reverse trade can be implemented (i.e., a sale of the pair at the higher price and a repurchase at the lower price).