Preparation or Devastation? Don’t Get Caught in a Bad Carry Trade

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. 

Figure 1 - USD/JPY Weekly Chart (NetDania)

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.  

Figure 3 - USD/JPY Forecast Poll (FXStreet) 

Figure 4 - USD/CHF Forecast Poll (FXStreet)