Carry Trade With Indices/Stocks

[teezeike]

Hi All,

Carry trade is not only for JPY/USD. In Forex, the risk could be the exchange rate which can wipe off and more remotely sudden aggresive government action.

In normal index/stock trading one can use this strategy without the risk of exchange rate or government action.

1. Buy Strong Index say DOW
2. Sell equivalent number of (1)Weak Index say Russel
3. Close both positions on relative profit
4. Enter again when the relative price is even

Explaination:

1. If you buy 1 qty of Dow at say 14000. You must buy 20qty of Rusell at 700. You can do the mathematics as per lots for futures traders.

2. You notice during trade if you look at charts that the price movement of both indexes are equivalent but not same. At each point in time..one must outperform the other. At a point where the outperformance can give you a profit taking into consiration your costs then you Close.
3. For me it is better to switch instead of waiting for even prices.
4. With this strategy, your trading is hedged so you can leave them and sleep and start another day.

 

[Rhody Trader]

What you're describing is not carry trading. It's spread trading. Carry trading is an attempt to take advantage of the interest rate differential between currencies. Your strategies are trading off of relative price performance.

 

[teezeike]

What you're describing is not carry trading. It's spread trading. Carry trading is an attempt to take advantage of the interest rate differential between currencies. Your strategies are trading off of relative price performance.

Hi,

The popular Carry Trade is to buy currency with lower int. rate and sell one with higher one. With the condition of strenght and weakness of the relative economies.

Carry trade as a subject is to buy strenght and sell weakness of markets that are equivalent. IT IS NOT only in terms of forex. You can implement this strategy in anything. More formally Carry Trade is to Sell assets in a lower intrest rate economy and buying one in a higher intrest rate one ensuring that the economy where you ae buying is strong enough.
Spread Trading is just the trading off of realtive price performance without consideration to the inherent strenght and weakness.

If for example you BUY Goldman Sachs and Sell equivalent of Bear Stearn taking into consideration their relative P/Es..that is carry trade. See the attached chart for 6- months performance.

View attachment bsc.bmp

 

[Rhody Trader]

The 'carry' in carry trade comes directly from the term for the interest paid/received when one holds a position overnight (or longer). The most basic carry trade is to sell (meaning borrow) a low interest rate currency such as the Yen and then buy (meaning deposit) a higher interest rate currency such as the Aussie Dollar. You thus earn the interest differential.

Consider that a forex trader can get 100:1 leverage or better and you can see the attraction of such a trade. A 5% interest rate differential in favor of the AUD becomes a 500% return for the trader if the exchange rates hold steady. That's the carry. Where's the carry in buying GS and selling BSC? Actually, you would have a negative carry because of your cost of borrowing the BSC shares to short.

Naturally, there is always a risk that in the forex trade the rate declines substantially enough to wipe out one's interest differential profits. The carry trade is not inherently a play on the exchange rate itself, though as more folks do it the rate increases, which adds to the profit of the position.

Hedge funds and such actually made things more complex by borrowing in Yen (and to a lesser degree Swiss Francs) and investing the proceeds in a number of different types of assets, which is part of what caused the dramatic carry trade currency pair sell-offs in August when they were forced to unwind positions.

 

[grantx]

Teezeike,

Whether you call it carry-trades or spread-trades isn’t important (although I agree with Rhody this is spread trading).

I think your idea is potentially dangerous – you are not trading like-for-like Any correlation is superficial, merely reflecting the whole market in general, specifically bullish - all indices rise.

But the DOW represent the US majors, the Russell represents small companies. In a sell-off, people will be more inclined to dump the smaller, more speculative stocks, less so for DOW constituents as these represent a (relative) ‘safe-haven’ in that they can be bought and held for the long term, regardless of market volatility.

This is precisely what screwed LTCM – trading relative value between lower and higher rated bonds. Market panic caused people to dump the more speculative thus causing the spread to widen (LTCM were short the lower rated, long the higher rated).

You (and LTCM) are not hedged.

May I suggest safer alternatives – Euro Stoxx futures vs DAX futures, Bund vs Bobl or Schatz futures, FTSE vs CAC futures?

Good luck.

Grant.

 

[teezeike]

I agree with you that the carry in the trade is to borrow..that is to sell. You borrow BSC and deposit GS.

In forex, Carry trade is a play on the interest rate differential. In indexes/stock it is a play relative performance drfferential. I both scenerio you could enjoy even up to 100:1 Leverage or better. Meaning that if you had sold BSC and bought GS 6 months ago you could earn 30% (that is 3,000%).

Spread Trading is a hedged play stock qty/stock qty. Meaning that $ value of one position is higher than the other. In spead trading if say the pair moves up 50%, you could gain if your upward $ value is higher and, conversely, down. Else you suffer losses.

Actually Carry trade is a market-neatral Play in dollar terms. Spread Trading is NOT. The skill required is in the selection of the market pair.

The 'carry' in carry trade comes directly from the term for the interest paid/received when one holds a position overnight (or longer). The most basic carry trade is to sell (meaning borrow) a low interest rate currency such as the Yen and then buy (meaning deposit) a higher interest rate currency such as the Aussie Dollar. You thus earn the interest differential.

Consider that a forex trader can get 100:1 leverage or better and you can see the attraction of such a trade. A 5% interest rate differential in favor of the AUD becomes a 500% return for the trader if the exchange rates hold steady. That's the carry. Where's the carry in buying GS and selling BSC? Actually, you would have a negative carry because of your cost of borrowing the BSC shares to short.

Naturally, there is always a risk that in the forex trade the rate declines substantially enough to wipe out one's interest differential profits. The carry trade is not inherently a play on the exchange rate itself, though as more folks do it the rate increases, which adds to the profit of the position.

Hedge funds and such actually made things more complex by borrowing in Yen (and to a lesser degree Swiss Francs) and investing the proceeds in a number of different types of assets, which is part of what caused the dramatic carry trade currency pair sell-offs in August when they were forced to unwind positions.

 

[teezeike]

Oh no there must be some misunderstanding.

You must be bullish on one Index and Bearish on the other.

For sure in DOW and Russell scenario that you painted, our example works perfect. People must dump smaller speculative to safe heavens in bad times. You don't need strength for strength pair. Rather what you need is strength/versus weakness. If The market is bullish the strength must outperform the weakness. If the market is bearish the weakness must under-perform the strength. In both cases you must have a profit.

Remember our approach is market neutral in $ terms.

Look at Dow/Russell carry play in the last 3 months. That is about 5% profit or 500% or more on leverage:
View attachment russel.bmp

Teezeike,

Whether you call it carry-trades or spread-trades isn’t important (although I agree with Rhody this is spread trading).

I think your idea is potentially dangerous – you are not trading like-for-like Any correlation is superficial, merely reflecting the whole market in general, specifically bullish - all indices rise.

But the DOW represent the US majors, the Russell represents small companies. In a sell-off, people will be more inclined to dump the smaller, more speculative stocks, less so for DOW constituents as these represent a (relative) ‘safe-haven’ in that they can be bought and held for the long term, regardless of market volatility.

This is precisely what screwed LTCM – trading relative value between lower and higher rated bonds. Market panic caused people to dump the more speculative thus causing the spread to widen (LTCM were short the lower rated, long the higher rated).

You (and LTCM) are not hedged.

May I suggest safer alternatives – Euro Stoxx futures vs DAX futures, Bund vs Bobl or Schatz futures, FTSE vs CAC futures?

Good luck.

Grant.

 

[grantx]

Teezeike,

I see your point. But I reckon it will take very acute analysis and interpretation of the underlying markets and economics; and your not making one prediction, but two. If you can do it, you'll have my respect.

Good trading

Grant.

 

[teezeike]

Teezeike,

I see your point. But I reckon it will take very acute analysis and interpretation of the underlying markets and economics; and your not making one prediction, but two. If you can do it, you'll have my respect.

Good trading

Grant.

Thanks grant.

It surely will require good mental work but no rocket science.

Take Motorla and Nokia for example. USA adopted CDMA..and pockets of other countries. Even now GSM is penetrating USA. Say about 300~500million populaion universe. Europe adopted GSM with loads of emerging markets ( and nill penetration of CDMA) say about 1~2billion population universe. Nokia is a top performer in lastmile solutions( handsets) within GSM sphere. Motorola is a low performer within CDMA sphere Qualcom is better. You Buy Nokia and Sell Motorola of same $ amount. For a long time to come this attached chart is not likely to change! Until Mot is bought over....but too big and complex..so by whom???

View attachment mot.bmp

 

[grantx]

Teezeike,

That's impressive. If you stick to pairs of stocks (rather than two universes - DOW, Russell), I reckon you'll do fine. Good luck, mate.

Grant.

 

[teezeike]

Yea Mate,
Indexes can provide rock solid hedge than individual stock. But then if you have to play stocks you need to ensure that they are large capitlized, liquid, same BETA. Or better too sector ETFs. Look at Mastercard/American Express, Western Union/Moneygram, XLB/XLF, Microsoft/Sun Microsystems, Intel/AMD pairs

Teezeike,

That's impressive. If you stick to pairs of stocks (rather than two universes - DOW, Russell), I reckon you'll do fine. Good luck, mate.

Grant.

 

[grantx]

Teezieke,

Thought of it but didn't note it: beta. Two stocks could be in different industries but have opposite betas, eg ABC equals 25%, XYZ = -25%. Any significant divergence from the betas may be potential.

If you have access to options prices, unusually high/low implieds may help. Of course, a higher implied doesn't always indicate direction but greater uncertainty re price - could be up or down. Perhaps it could be used to complement your initial analysis - your intended long may have an unusual high implied, therefore a potentially higher risk not apparent through fundamental analysis.

Many possibilities.

Grant.

 

[teezeike]

Teezieke,

Thought of it but didn't note it: beta. Two stocks could be in different industries but have opposite betas, eg ABC equals 25%, XYZ = -25%. Any significant divergence from the betas may be potential.

If you have access to options prices, unusually high/low implieds may help. Of course, a higher implied doesn't always indicate direction but greater uncertainty re price - could be up or down. Perhaps it could be used to complement your initial analysis - your intended long may have an unusual high implied, therefore a potentially higher risk not apparent through fundamental analysis.

Many possibilities.

Grant.

Thats makes sense. But this could be factored in as an exit strategy. Our entry strategy assumes same beta boundary and the pairs must be chosen from same sector universe. For example IBM/Microsoft pair does not belong to same sector universe. IBM does enterprise solutions as well as hardware. Microsoft has strenght in retail software, games and tending towards advertisement these days. HP and Dell could be perrfect plays Just as Tesco and Morrissons in the UK

 

[grantx]

Teezeike,

Good point re exit. Your way ahead of me.

Grant.

 

[luckyd1976]

Pair Trading

Does anyone know of a good book on Pair Trading? I've heard it can be really successful. Im still alittle fussy on expected returns, DrDowns, implementation though.

 

[teezeike]

Hi,

There are many resoources on the net.

Carry Trading is not trading though.

Pair Trading: markets that a tightly correlated. Market neutral.

Spread Trading: Strenght/Weakness: Hedged Position

Carry Trade: Strenght/Weakness: Market Neutral.

In any two markets that are related...say same sector of industry. One market is usually overpriced more than the other. Sell Over priced and buy the other. More than 80% of trading days, the better coy must outperform the other.