From the April 01, 2007 issue of Futures Magazine • Subscribe!

Tech Talk: Enhancing carry trades

Foreign exchange traders often participate in the age-old debate between the benefits of technical analysis vs. fundamentals. Is it better to rely upon news and economic indicators, or do the charts really contain what a trader needs to profit from the markets?

In forex, this question can be answered with a resounding “yes.” In other words, it is ideal to use both technical and fundamental analytical methodologies to achieve trading success.

It is just common sense for a trader to digest all the pertinent information before committing to a trade. Practically-speaking, however, how can technicals and fundamentals be combined effectively to produce profitable trades?

In foreign exchange, the answer can be found in a simple, but powerful, strategy that’s called the “Technical Carry Trade.”

On its most basic level, the traditional currency carry trade is a fundamental investment model that seeks to take advantage of central bank interest rate differentials. For example, a trader would go long the AUD/JPY because of the relatively high interest rate for the Australian Dollar compared with the very low interest rate for the Japanese yen. The trader would essentially borrow yen at a low interest rate to buy the Aussie, which pays a high interest rate. This creates a rate differential that can be exploited effectively with the additional utilization of leverage.

Used alone, the currency carry trade has long been a powerful tool to reap substantial and quantifiable interest rate returns. The risk of implementing this strategy, however, can far outweigh its benefits, as adverse moves in the exchange rate could drastically eclipse any interest gains.

And that is where the technical portion of this strategy enters in. If a trader combines the fundamental discipline of interest rate differential analysis with the technical phenomena of support and resistance, peppering in some sensible entry techniques and proper money management along the way, the results can be exceptional.

In the Technical Carry Trade, a trader would conduct analysis as follows:

Consider trading only those currency pairs with high interest rate differentials, 300 basis points or more, and include only those pairs where this differential is likely either to stay the same or increase in the foreseeable future. This requires considerable analysis on the fundamental side.

Among these currency pairs, seek out only those that are trading technically within or close to pre-defined support/resistance zones. For example, the bottom third of the annual price range can act as a support zone for a long-traded carry pair (see “Technicals carry the day,” below).

Once these fundamental and technical conditions are met, multiple scaled entries at regular price intervals in the direction of positive carry can be initiated. These would be small, fractional trades spaced evenly within the support or resistance zone. Profits can also be taken at regular intervals, and disaster stop-losses can be set at technically-indicated levels.

The Technical Carry Trade can be a reliable method of earning substantial interest returns while mitigating the risk inherent in the traditional carry trade. It also combines the best of technical and fundamental analysis.

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