What’s the Worst that Could Happen?

While global Central Banks are not cutting rates yet, their synchronized rate-hike-hiatus has made it a very real possibility heading into 2020.  If that happens, the beloved carry trade will fade off into the sunset as the market punishes traders that didn’t protect their downside.  Some would argue that there is still room to run in this cycle (and they may be right), but the increasing risks of implosion certainly warrant a more prudent approach to the carry trade. 

Long USD/JPY and Long USD/CHF have been the most popular carry trades during the most recent tightening cycle and should remain that way if US Dollar strength and low FX volatility persists.  But what happens if that changes? 

If we do see the end of the tightening cycle, you will likely see liquidation begin in these positions. As most of the early exiting will come from hedge funds and other large traders, the crash could be fast and furious.  The implosion is further exacerbated by the high degree of leverage in FX markets, and those who are late to the party will be in a world of pain.  Once the loss on the position exceeds the average annual yield from the carry, the trade is toast. 

USDJPY

Figure 1 - USD/JPY Weekly Chart (NetDania)

USDJPY

Figure 2 - USD/CHF Weekly Chart (NetDania)

Protecting the DownsideThose who are not ready to take money off the table should at least be looking to protect it.  Novice traders often find themselves in a single carry trade without being hedged, which is how trouble starts.  Experienced traders instead own a portfolio of carry trade positions that lowers risk through diversification.  This is great if you see a drop in just a single pair, but the others move in your favour.  But this alone won’t insulate you from downside risks of a broad USD selloff.  This is where options come in.

calls are worth a look.  The trick is finding an OTM option with a low enough premium that it doesn’t eat up your carry profits, but not to far OTM that the protection is insufficient against devastating spikes in JPY or CHF.

Another strategy that has gained traction is selling puts rather than buying calls. When Put sales are combined with a carry trade, you get additional yield from the premium.  This is great in low volatility environments, but if central banks stop tightening there will be downside risks.  It is more prudent to hedge these with a collar strategy to reduce costs of hedging, but you will be forgoing some upside.  

1 Week
Avg Forecast 112.27
100.0%92.0%75.0%07580859095100
  • 75% Bullish
  • 17% Bearish
  • 8% Sideways
Bias Bullish
1 Month
Avg Forecast 111.26
0.0%100.0%43.0%0-100102030405060708090100110
  • 43% Bullish
  • 57% Bearish
  • 0% Sideways
Bias Bearish
1 Quarter
Avg Forecast 110.77
100.0%93.0%36.0%030405060708090100
  • 36% Bullish
  • 57% Bearish
  • 7% Sideways
Bias Bearish

Figure 3 - USD/JPY Forecast Poll (FXStreet) 

1 Week
Avg Forecast 1.0028
100.0%89.0%56.0%0556065707580859095100
  • 56% Bullish
  • 33% Bearish
  • 11% Sideways
Bias Bullish
1 Month
Avg Forecast 0.9977
100.0%77.0%32.0%030405060708090100
  • 32% Bullish
  • 45% Bearish
  • 23% Sideways
Bias Bearish
1 Quarter
Avg Forecast 0.9945
100.0%83.0%32.0%030405060708090100
  • 32% Bullish
  • 51% Bearish
  • 17% Sideways
Bias Bearish

Figure 4 - USD/CHF Forecast Poll (FXStreet) 

Note: All information on this page is subject to change. The use of this website constitutes acceptance of our user agreement. Please read our privacy policy and legal disclaimer. Opinions expressed at FXstreet.com are those of the individual authors and do not necessarily represent the opinion of FXstreet.com or its management. Risk Disclosure: Trading foreign exchange on margin carries a high level of risk, and may not be suitable for all investors. The high degree of leverage can work against you as well as for you. Before deciding to invest in foreign exchange you should carefully consider your investment objectives, level of experience, and risk appetite. The possibility exists that you could sustain a loss of some or all of your initial investment and therefore you should not invest money that you cannot afford to lose. You should be aware of all the risks associated with foreign exchange trading, and seek advice from an independent financial advisor if you have any doubts.

Education feed

Editors’ Picks

EUR/USD: risk-off taking over on trade war escalation

The American Dollar sold off Friday, following US President Trump´s anger discharge on Twitter. The pair soared to 1.1152, its highest for the week, to finally settle at around 1.1140.

EUR/USD News

GBP/USD: Johnson and Tusk engaged in the blame-game

The GBP/USD pair flirted with the 1.2300 figure late Friday, ending the week with substantial gains around 1.2280, backed by Brexit hopes and the dollar’s broad weakness.

GBP/USD News

USD/JPY: lower lows at sight on the run to safety

The USD/JPY pair sunk Friday, following US President Trump’s fury with China and Fed’s head Powell, as the market rushed into safety. US yield curve inverted again, fears of recession rule.

USD/JPY News

Editors’ Picks

EUR/USD: risk-off taking over on trade war escalation

The American Dollar sold off Friday, following US President Trump´s anger discharge on Twitter. The pair soared to 1.1152, its highest for the week, to finally settle at around 1.1140.

EUR/USD News

GBP/USD: Johnson and Tusk engaged in the blame-game

The GBP/USD pair flirted with the 1.2300 figure late Friday, ending the week with substantial gains around 1.2280, backed by Brexit hopes and the dollar’s broad weakness.

GBP/USD News

USD/JPY: lower lows at sight on the run to safety

The USD/JPY pair sunk Friday, following US President Trump’s fury with China and Fed’s head Powell, as the market rushed into safety. US yield curve inverted again, fears of recession rule.

USD/JPY News

Powell powerless against Trump's trade wars – US braces for recession, USD set to move

"The most powerful central banker in the world" – is how we and others characterize Fed Chair Jerome Powell. While that may be true – monetary policy is reaching its limits – especially in the face of a trade war.

Read more

Gold gains more than $30, eyes 2019 highs on Trump’s tweet

Gold continues to rise sharply amid concerns about the impact of the escalation in the US-China trade war. The demand for safe-haven assets emerged over the last hours, leading to a rally in the yellow metal. 

Gold News

RECOMMENDED LESSONS

7 Ways to Avoid Forex Scams

The forex industry is recently seeing more and more scams. Here are 7 ways to avoid losing your money in such scams: Forex scams are becoming frequent. Michael Greenberg reports on luxurious expenses, including a submarine bought from the money taken from forex traders. Here’s another report of a forex fraud. So, how can we avoid falling in such forex scams?

What Are the 10 Fatal Mistakes Traders Make

Trading is exciting. Trading is hard. Trading is extremely hard. Some say that it takes more than 10,000 hours to master. Others believe that trading is the way to quick riches. They might be both wrong. What is important to know that no matter how experienced you are, mistakes will be part of the trading process.

Strategy

Money Management

Psychology