The Carry Trade and Volatility

In our ETF based newsletter, the carry trade is one of the strategies that we employ. For those unfamiliar with the carry trade, you are essentially trading the interest rate differentials of different countries. You short a low-yielding currency and go long a higher-yielding currency.

You can make money in two ways. You earn the “carry” if the currencies remain very stable, and neither move. You can also make money in this trade by being correct in the direction. For instance if you are short the Japanese Yen and long the Australian dollar, then you can also make money if the Australian dollar goes up, and the Yen goes down.

As an example of how to earn the carry, lets look at the Japanese Yen versus the Australian Dollar. The Yen has been the carry trade vehicle of choice for much of the past decade because Japan has consistently had extremely low interest rates. Australia, on the other hand, has had relatively high rates over the last decade.

To construct the differential for this trade, take one rate and subtract the other rate. In the chart below, we plot the difference between the AUD and the Yen since the beginning of 2007. As you can see, at one point the carry was as high as 7.34, but it has since declined to 2.69. If you had been long the AUD and short the Yen, you would have earned this interest rate differential the whole time.

AUD-JPY Interest Rate Differential

AUD-JPY Interest Rate Differential

Of course as we already mentioned, in order to make money on the carry trade, your long must outperform or stay flat relative to your short position in order to make money since a big directional move against you will wipe away any gains that you would be making solely off the carry.

There have been several academic studies as well as real world trading results that show that volatility is the biggest risk that the carry trade faces. Over the years, most studies were stuck using the SP500 VIX as a proxy for global financial market volatility. While it correlates quite well, there are now some far better options to help track and manage risk in the currency markets. We at The Macro Trader use the JP Morgan G-7 VIX index for our carry trading model as it correlates extremely well to the volatility in the DBV-Currency Harvest Trust ETF.

What we first found in the academic literature, later confirmed by our own testing and used successfully in our trading, was that when volatility in the currency markets is flat or declining, the carry trade works very well. On the other hand, when currency volatility is high, the carry trade typically is a money loser because the directional aspect of the trade overwhelms the carry, giving you a loss.

We look at the JP Morgan G-7 VIX using two different charts. The first one is a reversion to the mean chart where plot the VIX data, the historic mean, then one and two standard deviations above and below the mean. When volatility is high and then falls below one standard deviation, we start looking to enter the carry trade and when it get above the one standard deviation line we would sell if not already stopped out. On the downside, we look to sell when volatility declines too much since it represents excessive complacency and usually is a sign of higher volatility ahead.

JP Morgan G-7 VIX


The other way that we like to look at the currency VIX is to invert it on a chart alongside the DBV. As you can see in the below chart, not only was equity volatility declining, but DBV managed to base for a few months before climbing higher and then consolidating at its 200-day moving average. Finally today it was able to break out to the upside.



Finally we have the DBV itself. As you can see in the chart below, not only was equity volatility declining, but DBV managed to base for a few months before climbing higher and then consolidating at its 200-day moving average. Finally today it broke out to the upside.

DBV-Carry Trade ETF


Hopefully you see how volatility is bad for a lazy trade like the carry trade where you trying to get paid for sitting. If volatility climbs above 1 standard deviation above its mean we will look to tighten our stops as the odds of a downside move increase significantly.

DBV-G-10 Currency Harvest Fund is an ETF that goes long the three highest yielding currencies of the G-10 and shorts the three lowest yielding currencies on a 2x levered basis. While investors can go into the spot and futures FX markets and put on the same trade the DBV is a very simple way to gain exposure to positive carry in the currency markets.

Happy Trading,

Disclaimer-We currently hold positions in the DBV-G10 Currency Harvest Fund and FXA-Australian Dollar ETF.

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Title: The Carry Trade And Volatility

A Simple SP500 Timing Model

We track hundreds of different economic, fundamental, technical, sentiment, and cycle indicators. Some are stand alone and only help us discern particular situations while others are full blown timing models that we use to get in and out of the market. Some are very complex with ten and even twenty inputs ranging from jobless claims, to put call ratios, to nickel, to the advance decline line. Essentially anything that we test that helps to give us an edge we use to some degree or other. As global macro traders we of course have several models for every market that we trade, as well as models that only point us to markets showing abnormal movement.

As of a few days ago we had one of our longer term SP500 timing models trigger a buy signal. This timing model is very simple and only uses the NYSE Advance Decline line and the SP500 closing price. This models esge is not huge but it is solid and historically you are risking about 1:1 meaning that the historical return is almost the same as the worst historical drawdown.

In our newsletter and in our own trading we rarely use a model as an automatic buy or sell signal but we do use them to tell us which dorection to trade. Right now this extremely simple model is showing that the advance delcine line has finally been able to have a sustained run and break above its long term trend, in this case the 150-day moving average. Again we don’t, and don’t recommend, trading directly off of these signals as almost every model we track can be improved upon by selecting better entry and exit points but they do helo us tremendously in our trading.

SP500-NYSE Advance Decline Line


As you can guess we are becoming increasingly bullish after being bearish for the better part of two years. Who knows if this rally will continue as there are a ton, and maybe a trillion tons, of harsh economic realities and hardships, but for now the trend is up and we are starting to lean to the long side.

Happy Trading,

P.S. If you are getting value out of our posts, you can do us a favor by linking to us with your site or blog and mentioning The Macro Trader to any of your friends that trade.

Macro Trading Versus The SP500

Macro Trading has many benefits versus equities. As mentioned before a global macro trader can trade in any asset class, in any country, using any strategy. So what are the benefits of these freedoms? Well there are many but here we will focus on two of them. First is that using multiple asset classes, countries, and strategies we are able to get a more consistent stream of returns. When one asset class zigs one is zagging. If we blend them together well we can end up with a very steady stream of returns.

This chart shows $1000 invested in the Barclays Group Global Macro Index versus $1000 invested in the SP500 from the beginning of 1997 to the end of September 2007.

The other major benefit we will discuss here is that our risk profile is much better. The worst drawdown in the SP500 since 1997 was -46.28%. Now compare that to the Barclays Group Global Macro Index where your worst drawdown was only -5.22%.

Charts showing drawdowns for Macro Index and SP500 1997-September 2007

You can see that there is more than just a slight difference. Where the SP500 is more or less at breakeven for the past seven years the Macro Index has never taken longer than eight months to make a new high.

If you are only trading or investing in one asset class or if you are only trading in the United States please look at some of the benefits of adding some asset classes, countries, and trading strategies to your portfolio. Long term we think you will be happy you did.

Happy Trading,

The Macro Trader