Thursday, November 02, 2006
Carry trades
Carry trades
The foreign exchange market, or forex, is the largest market in the world with $1.9 TRILLION trading hands daily. It is by far the largest global market.
The forex market allows for serious leverage on trades, as high as 400:1. This means to acquire the rights to $100,000 I need to only put up $250. The inter banks will loan me the other 99.75% I need to make the trade.
When you buy and sell positions on the market, you are borrowing money from a bank in one currency and depositing in another bank with a different currency. When I buy euros with USD I am literally moving my US dollars from a US bank into a European bank with Euro based accounts.
Of course, when money is borrowed you have to pay interest, right? When you make a trade on leverage the money is borrowed from one bank with interest and invested in a bank that pays dividends. CHA CHING!
Currently I can borrow money from a Japanese inter bank for investing on the forex markets for just a .37% interest rate. Depositing this borrowed money into a US inter bank will give me 4.455% interest a year in profit after the Japanese rate is deducted.
4.455% per year is practically nothing, I could keep my money domestically in an online bank and achieve that ROI. This is where the power of leverage comes into play. If I am borrowing at 50:1 leverage my ROI instantly shoots to 222% per year! Compounded daily rather than just annually it comes out to 921% per year!
Why this works:
Japan is having a hard time to even get borrowers for their finance industry. In order for the economy to keep moving, money has to be out working to generate revenue.
At one point, one could borrow from Japanese inter banks for zero interest because of how slow the Japanese economy was progressing. US banks are offering high rate of returns because of the quick growth in the US economy. Rates are artificially kept high to stunt inflation concerns.
I would never recommend taking a position solely for the interest payments. These investments return so much because the amount of risk is practically astronomical. Trading at 50:1 leverage is something that should never be attempted without sufficient account balances. If a trader is fully leveraged he or she can lose all of their money on just a 2% loss.
The opposite is also true. If the currency pair were to progress 2% in your favor, at 50:1 leverage you would have doubled your money! These high rates of return are not sustainable, you should not at any time attempt to do this kind of trading.
The risk in these investments is high. Because of the leverage in this scenario is as high as 50:1, a 2% drop in your currency investment will lead to a 100% loss on your account. These swings are extremely common as a currency can gain or lose 2% over the course of a week and 10%+ over a month timeframe.
Investments like this are not recommended, they are just used for illustration of investment theory and the possibilities in the forex markets. Do not attempt 50:1 leveraged trades without a sufficient amount in your account to counterbalance heavy margin trading. While there is no risk of losing more than you have invested, you can lose everything in just a few ticks.
When trading forex it is recommended that you trade no more than 2-3% of your balance at any one time and plan on being able to lose 1-2% on each trade. Slow and steady wins the race, just ask the world’s richest investor, Warren Buffett.