Volatility the Carry Trade and The Macro Trader
Macro traders trade virtually everything. They trade stocks, bonds, commodities, and currencies looking for uncorrelated trade ideas with great risk to reward characteristics. Sometimes they will even venture into markets like real estate and even art.
They trade not only different asset classes but multiple strategies within each asset class. For instance in stocks they will trade outright long and short positions, merger arbitrage deals, asset class arbitrage where you trade the equity against debt, and even pairs trading. They do much of the same in commodities and currencies as well. Essentially they are looking for sources of return wherever they can find it.
One of the best places for macro traders to really differentiate themselves from other categories is in the currency carry trade. While most people understand what a directional bet is, one in which you buy or short something and if it goes up or down you make money, many do not understand carry.
The carry trade consists of going long a high yielding currency and going short a low yielding currency to fund the trade. You make money in two ways. One is if the initial trade is profitable if the higher yielding currency goes up relative to the low yielder. The other way to earn money is to make money off the carry, or the interest rate differential.
The carry trade is helped tremendously by the use of leverage. If you can earn four percent via the differential and then magnify that by four or five you will then bring your returns up to sixteen or twenty percent a year from the carry alone. If you juice it up ten times you will have a forty percent return. This sounds great on paper but it cant be that easy can it?
No, it is not. Yes, you can get the carry but if there is excess or even normal volatility depending upon the leverage being used you will blow up in traders terms. If this is the case, and it is, then what should a trade be focusing on when they are trying to execute the carry trade? Well the obvious answer is volatility.
There are a gazillion ways to measure volatility but some of the best ones are by using an actual volatility index. We have the VIX on the SP500 which is a surprisingly good measure of financial volatility and is suitable for currencies as well. But these days we have some volatility indexes from many of the investment banks which make it far easier to measure currency volatility and back test ideas.
If you are an active macro trader that is using the carry trade then you should incorporate a volatility filter. If you are not using the carry trade then you are missing out on a great way to diversify as well as deliver more consistent returns. - 23199
They trade not only different asset classes but multiple strategies within each asset class. For instance in stocks they will trade outright long and short positions, merger arbitrage deals, asset class arbitrage where you trade the equity against debt, and even pairs trading. They do much of the same in commodities and currencies as well. Essentially they are looking for sources of return wherever they can find it.
One of the best places for macro traders to really differentiate themselves from other categories is in the currency carry trade. While most people understand what a directional bet is, one in which you buy or short something and if it goes up or down you make money, many do not understand carry.
The carry trade consists of going long a high yielding currency and going short a low yielding currency to fund the trade. You make money in two ways. One is if the initial trade is profitable if the higher yielding currency goes up relative to the low yielder. The other way to earn money is to make money off the carry, or the interest rate differential.
The carry trade is helped tremendously by the use of leverage. If you can earn four percent via the differential and then magnify that by four or five you will then bring your returns up to sixteen or twenty percent a year from the carry alone. If you juice it up ten times you will have a forty percent return. This sounds great on paper but it cant be that easy can it?
No, it is not. Yes, you can get the carry but if there is excess or even normal volatility depending upon the leverage being used you will blow up in traders terms. If this is the case, and it is, then what should a trade be focusing on when they are trying to execute the carry trade? Well the obvious answer is volatility.
There are a gazillion ways to measure volatility but some of the best ones are by using an actual volatility index. We have the VIX on the SP500 which is a surprisingly good measure of financial volatility and is suitable for currencies as well. But these days we have some volatility indexes from many of the investment banks which make it far easier to measure currency volatility and back test ideas.
If you are an active macro trader that is using the carry trade then you should incorporate a volatility filter. If you are not using the carry trade then you are missing out on a great way to diversify as well as deliver more consistent returns. - 23199
About the Author:
If you need actionable trading ideas then check out The Macro Trader It is a weekly global macro trading advisory publication with frequent intra-week updates for time-critical analysis and actionable trading ideas.
posted by X - Men @ 12:13 AM
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