Hi everyone,
This is something I should have posted in early June when I warned everyone about a potential carry trade unwind. I’m sorry I didn’t think to do it. Perhaps it will help yet, or during the next unwind (yes, there will be another one). Once the current risk issue is old news, I believe that the carry trade will become popular again, and even post new highs in carry trade currencies.
A question everyone must ask himself or herself before entering ANY trade,
“What is my exit and/or hedge strategy?” That is true even for "boring" trades.
Let’s assume that we have a correlated carry trade long both GBPUSD and USDJPY. The obvious first strategy is to bail out before the market falls, especially if you are in profits. This is not a bad strategy even if the trade is in a relatively small drawdown.
But what if you are stuck in the trade for some reason and can’t close it out without disaster? Now you get to be a real trader and predict the depth and duration of the fall. Fun, huh? You have at least three choices.
- Buy put options as a hedge.
- Set up a counter directional trade. Using the example above, you would go short both the GBPUSD and USDJPY with the same lot sizes as the original trade. The hope/plan/goal/wild fantasy is to close out these short positions at the bottom with the profits offsetting most of the drawdown faced by the still open long positions. This is tricky to do. Very tricky.
- The third choice requires a little explanation and involves taking a short position in the cross currency. In this example, it is the GBPJPY. What size position is needed? To answer that, we need a little math.
First, we must understand that every pair of currencies and their cross is mathematically related in terms of price.
Huh? 
That means that if the price moves in one currency, it MUST be reflected in one or both of the other two pairs. If this does not happen, an arbitrage opportunity exists and I promise you that there are fancy computers at big banks that search for exactly this imbalance and will trade it back into balance very quickly. There will be short-term imbalances (such as during Non-Farm Payroll Friday), but these are due to broker inefficiencies and are quickly eliminated.
The formula is simple:
Currency pair one price (GBPUSD) x Currency pair two price (USDJPY) = cross currency price (GBPJPY). FYI, it will be off by a few pips due to the brokers’ spread.
Now here is where it gets interesting. Assume a 100 pip fall in both the GBPUSD and USDJPY. Will the GBPJPY fall 100 pips? 200 pips? 50 pips? Nope. Here is the math using a 100 pip move up/down in one/both of the major pairs and how it is reflected in the cross price as well as the delta. See the chart attached below.
To answer the question, if both the GBPUSD and the USDJPY fall 100 pips and both pairs have equal lot sizes, the GBPJPY cross will fall 319 pips. The reverse is true – a fall of 319 pips in the GBPJPY (if that cross currency is the driving force), there will be a combined total of 200 pips drop in the GBPUSD and USDJPY. But remember that all three push and pull on each other constantly, which affects price for all three.
So, if you choose to use the cross to hedge the carry trade, be aware that if the lot size matches the two major currencies the movement will be larger, and the trader could consider hedging with a smaller lot size on the cross. Check the math to determine what size that should be. In this case, a .62 lot size just about hedges the trade.
Pop Quiz: In this situation why does the cross move 319 pips when the two majors move 100 pips each? I will give a free three-month C4 live account lease to the first person that can give me the correct answer to that question.
Trade carefully,
Bill
