Definition of a forex carry trade: A strategy in which a forex trader sells a certain currency with a relatively low interest rate (like the JPY/yen) and uses the funds to purchase a different currency which yields a higher interest rate (like the GBP/pound). A trader using this strategy captures the difference between the two rates, which depending on the amount of leverage used, can often be substantial. For each day that you hold this trade, your broker pays you the interest difference between the two currencies as long as you are trading in the interest positive direction, in addition to whatever gains the pair may be making. This interest differential would even work towards offsetting losses.
An example: Let's say the JPY yen had a 0% - 0.5% interest rate as it did back in 2006, and the GBP pound had a 3-4% interest rate. You would buy or go long on the GBPJPY, which meant you were using 0% yen to buy the 4% pound. For every day that you had that trade on the market, your broker paid you the difference between the two currencies' interest rate less their percentage. This added up over time especially when you factored in leverage. By trading in the direction of the carry interest, you not only got your trading gains, but you also got interest gains, which were based on the leveraged amount. These were the days of trading 100:1 or 200:1 leverage, so your interest rate was substantial and resulted in large returns. So it made sense that when the market was in a "feeling safe" zone and in a positive mood, the carry trade worked extremely well. Look at a GBPJPY chart from 2000-2007 and you can see the steady and moderate climb that the pair was making.
From 2006 to 2007 we were part of a new trading room and the buzz was all about this particular style of trading. It was easy to understand, simple to place a trade and it had been working for a long time, so the guarantee of its success was pretty assured. In the middle of 2007, the GBPJPY had risen over 7% already that year. In 2006 it had gained 10% and 3% in 2005. Using leverage your gain could easily be over 40% annually and some traders were making 100% per year using even more aggressive leverage than we were.
The person who was heading our trading room was a wealthy, experienced currency trader living in Mexico (presumably to hide the massive wealth he was amassing), and had millions of dollars of his own as well as his own client's money riding on it. We were in multiple positions using a grid entry method. As one position took profit, we would add another one on at regular intervals. We saw our balance grow and grow and grow and there was little that we had to do. The strategy relied on the steady growth of the pair and interest payments to offset temporary drawdowns. This was all in lieu of using stops. We checked our trade everyday, noted our growing balance, and added on. The GBP was steadily climbing and we were feeling very good about our positions.
A few times Mindy would ask our mentor about his worst case emergency plan if things turned around and the price on the GBP would start dropping. Looking back on charts she pointed out that prior to 2000 the pair we were trading had taken an almost 40% hit falling over 9,000 pips from August 1998 to September 2000 and she was worried about the possibility of that happening again in the future. We were constantly assured by our mentor that trading forex was different now and that that particular scenario wouldn't be happening again. He would tell us to look back and see that this pair hadn't had a drawdown bigger than 20% in the last 6 years. And he reassured us over and over again that he had a plan in place if things turned around, so there was nothing for us to worry about.
I remember the exact day things came crashing to a halt. We were in San Miguel de Allende, Mexico, the week of August 12th, 2007 on a family vacation with our kids and some friends. Everyone was in the living room playing music and laughing and we were in the bedroom watching the GBPJPY plummet to depths we couldn't even fathom. It started with the liquidation of two of Bear Stearns' hedge funds July 16, 2007, and then BNP Paribas (a French bank) announced that it was no longer trading three huge funds that specialized in U.S. mortgage debt. At this time banks were holding trillions of dollars worth of mortgages and they were all nervous. Interbank lending rates skyrocketed and banks stopped wanting to lend to each other. The TED Spread, which measures market stress, leapt up above 2% after staying below 0.5% the prior year.
Stock markets around the world started to fall and the yen, perceived as a safe haven currency, started to gain in value. We watched in abject horror as our equity started shrinking by the moment and still we were sure that it would turn around. We tried to reach our mentor to find out what our escape plan was but of course, he was not available. Undoubtedly he was doubled over his own toilet retching his guts out, same as us. That day we watched in panic as we saw the GBPJPY drop about 1000 pips from where we had bought it.
And then we heard the dreaded sound of our first margin call. We were stunned and numb with disbelief. And sick to our stomachs. We had lost way more money than we could believe or ever talk about and we had no one to blame but ourselves. Yes, our mentor lost over $2 million dollars, but that didn't make us feel any better. We had put our trust in him and he had no emergency plan.
In the next year and a half, the GBPJPY dropped 13,000 pips to 118.27 from where we had last bought it at 241.52.
It was our next reminder that in forex anything can and probably will happen. To be continued…
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