Carry, what is it and what does it Do?

“Carry” refers to the difference in interest rates between the two currencies in a currency
pair, and is one of the major drivers in the foreign exchange market. Carry can be likened to a
dividend, paid by a stock, but with two key differences. First, carry is paid daily, and second,
carry can be negative – which means carry can actually cost you money, as well as make you
money. Currently (and usually) commodity currencies like AUD and NZD have the highest
interest rates, while funding currencies, like USD and JPY have the lowest. Therefore, buying
AUD against USD and JPY yields a trader a positive carry, whereas selling AUD using USD and
JPY yields a negative carry.

Why do we Care about Carry?
There are three major reasons why traders should care about carry. The first is that it adds
up. While the amount of money added or subtracted from your account is generally small,
holding a position with negative carry for a long period of time will eat into your profits, and
must be taken into account when determining your trading plan.

The second reason traders care about carry is because carry helps determine the overall
direction of the market. There are cases where the opposite is true, but on average, it indeed
does dictate price action. When traders want to buy riskier assets they buy currencies with
higher carry, meaning AUD benefits in a risk-on atmosphere, while USD and JPY suffer. The
reverse is also true.

Thirdly, interest rates, like dividends dictate if a currency is going to perform well or not. A
higher interest rate bodes well for currency performance because a higher carry makes the
currency more desirable to traders.

What Drives the Forex Market?

Speculation/Expectation

If a market speculator thinks that one central
bank will be more aggressive in raising rates
than another central bank, the speculator will
buy the currency of the more aggressive
central bank relative to another in anticipation
of a change in the key overnight interest rate.
For example, if traders start anticipating that
the Reserve Bank of Australia will raise their
interest rates, the AUD/USD will start rallying,
as will pairs like AUD/NZD – as long as the
Reserve Bank of New Zealand is not expected
to match the rate increase.

A good gauge of expectations are the BBA
Libor (British Bankers Association, London
Interbank Offered Rate), which is an average
of interest rates outlooks by leading banks
with durations ranging from intraday to yearly
outlooks.

Another great gauge of expectations is the
Credit Suisse overnight index swaps (OIS),
which provide a percentage chance of a rate
cut by central banks. For reference purposes,
it is the difference between the LIBOR and OIS
which allows participants to measure
sentiment along with liquidity in the market
place.

Sentiment

This is one area that is not often
talked about but very important to
understand. Investors will
completely ignore carry and interest
rates when market sentiment turns
bearish.

One thing that people carry about
more than carry trade is safety.
Some examples of fear being
injected into the market include
contagion (the spread of the
European debt crisis), natural
disasters, terrorism, or the collapse
of major banks, as was seen in 2008.
When investors become fearful, they
seek safety. Safety is found in low
yielding currencies such as the U.S.
dollar, also known as the greenback,
and these low yielding investments
become the preferred choice of
investors.

All in all, interest rate expectations are essential to understanding not only the carry trade,
but also understanding how price action is affected by speculation and/or sentiment. It is
worth noting, however that while EUR/USD is the most popular pair to trade, currencies such
as the Australian dollar are more attractive due to their interest rate appeal.

In a married put strategy, an investor purchases an asset—such as shares of stock—and simultaneously purchases put options for an equivalent number of shares.2 The holder of a put option has the right to sell stock at the strike price, and each contract is worth 100 shares.

An investor may choose to use this strategy as a way of protecting their downside risk when holding a stock. This strategy functions similarly to an insurance policy; it establishes a price floor in the event the stock's price falls sharply. This is why it's also known as a protective put.

For example, suppose an investor buys 100 shares of stock and buys one put option simultaneously. This strategy may be appealing for this investor because they are protected to the downside, in the event that a negative change in the stock price occurs. At the same time, the investor would be able to participate in every upside opportunity if the stock gains in value. The only disadvantage of this strategy is that if the stock does not fall in value, the investor loses the amount of the premium paid for the put option.

In the P&L graph above, the dashed line is the long stock position. With the long put and long stock positions combined, you can see that as the stock price falls, the losses are limited. However, the stock is able to participate in the upside above the premium spent on the put. A married put's P&L graph looks similar to a long call’s P&L graph.

Fundamental Analysis

Fundamental analysis is the study of the strengths and weaknesses underlying the economy of a nation’s economy, and relating those findings to its currency. In very general, overbroad terms, positive economic data is good for a currency, because economic growth leads to increased interest rates, which leads to a better carry, and traders want to own high yielding currencies.

In addition to the interest rates that currently exist, traders are often focused on interest rate EXPECTATIONS – or where the interest rate will be after the next central bank meeting. These interest rate expectations are equally (or even more) important to determining the strength of a given currency as the current interest rate. These interest rate expectations are highly influenced by economic data releases. These data releases can and often do cause great market volatility, and extreme moves in price. It greatly behooves a trader to know when economic data is being released – please check out our “Key Economic Events”, available on the WrightInv.com homepage.

Do Fundamentals Really Matter?

There are a number of traders who believe that fundamental analysis is irrelevant, and that price (technical analysis) is the only relevant aspect to currency trading. Here at Wright Time Capital Group; however, we believe that both technical and fundamental analyses are essentially for a trader to have success. Certainly fundamentals alone are not enough to ensure profitability – a trader also needs a good sense of timing, and a way to determine a profitable strategy and risk / reward ratio. Fundamental analysis alone cannot do it all. Fundamentals do, however, paint a broader picture, and allow traders to maximize their capital by specifically targeting setups that take advantage of fundamental strengths and weaknesses in the underlying global economy.

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Key Economic Events

While there are dozens of different, important economic events, this page provides you with a brief introduction into arguably the three most important – employment, inflation, and Central Bank rate decisions.

Non-Farm Payrolls and Employment Data

One of the largest economic data movers in the global financial markets, employment data, but more specifically Non-farm Payrolls serves as a guage of employment in the public and private sector along with the unemployment rate.

Consumer Price Index (Inflation)

Central Bank Decisions

One of the mostly watched central bank interest rate decision is the Federal Open Market Committee (FOMC). The focus of the FOMC are price stability and to promote employment. As the latter is necessary for economic expansion, it is also worth noting the dual mandate which combines a lower combating of consumer prices.

How does this impact the currency market? Higher yields translates into a stronger greenback relative to its counterpart, with the opposite also holding true.

With calls, one strategy is simply to buy a naked call option. You can also structure a basic covered call or buy-write. This is a very popular strategy because it generates income and reduces some risk of being long on the stock alone. The trade-off is that you must be willing to sell your shares at a set price—the short strike price. To execute the strategy, you purchase the underlying stock as you normally would, and simultaneously write—or sell—a call option on those same shares.1

For example, suppose an investor is using a call option on a stock that represents 100 shares of stock per call option. For every 100 shares of stock that the investor buys, they would simultaneously sell one call option against it. This strategy is referred to as a covered call because, in the event that a stock price increases rapidly, this investor's short call is covered by the long stock position.

Investors may choose to use this strategy when they have a short-term position in the stock and a neutral opinion on its direction. They might be looking to generate income through the sale of the call premium or protect against a potential decline in the underlying stock’s value.

In the profit and loss (P&L) graph above, observe that as the stock price increases, the negative P&L from the call is offset by the long shares position. Because the investor receives a premium from selling the call, as the stock moves through the strike price to the upside, the premium that they received allows them to effectively sell their stock at a higher level than the strike price: strike price plus the premium received. The covered call’s P&L graph looks a lot like a short, naked put’s P&L graph.

Technical analysis is the study of price charts, in an attempt to forecast where price is headed next. There are dozens of different ways to do technical analysis, but we’ll cover a few basics
here, to get you started. First, a note about timeframes: Forex traders use a number of different timeframes for trading – the most common of which being the daily, four hourly, hourly, and 15 minute time frames. These timeframes refer to what period of time each bar, line, or candlestick represents. For example, a new bar appears every hour on an hourly chart. 

Chart Types

There are several different types of charts used by forex traders, but the three most popular are the bar chart, the line chart, and the candlestick chart. 

The Line Chart

A line chart is a very simple chart that traces the price action using a simple line. The line color shows whether the price increased or decreased during the time period of the line – red for down, blue or green for up. The line chart is the simplest possible chart, and
does not provide a lot of additional information. It is not often used by traders, who prefer either the bar chart, or more commonly, the Japanese candlestick chart.

The Bar Chart

The bar chart is a slightly more complicated and more informative type of chart used by forex traders. Bar charts provide more information than line charts, and give a much better indication of the price action within a given time period. In order to demonstrate what additional information is provided by a bar chart, we must take a closer look at the bars that comprise the chart.