If you are a global macro trader you trade anything and everything as long as you can find an exploitable edge. The majority of your trades are across asset classes trading stocks, bonds, commodities, and currencies. You are looking for uncorrelated returns from multiple asset classes.
You don't just trade different asset classes but even different strategies within an asset class. If you trade bonds you will have some directional trades on, some spread trades, and some arbitrage trades. All of his is to further diversify your returns stream. You can do the same types of things in every asset class which makes your streams of returns very uncorrelated.
One area that is particularly suited to the macro trader is that of the currency markets. Yes, they trade currency crosses and build their own cross baskets but macro funds are also known to trade one strategy called the carry trade quite frequently.
The carry trade consists of going long a high yielding currency and going short a low yielding currency to fund the trade. You make money in two ways. One is if the initial trade is profitable if the higher yielding currency goes up relative to the low yielder. The other way to earn money is to make money off the carry, or the interest rate differential.
The carry trade is helped tremendously by the use of leverage. If you can earn four percent via the differential and then magnify that by four or five you will then bring your returns up to sixteen or twenty percent a year from the carry alone. If you juice it up ten times you will have a forty percent return. This sounds great on paper but it cant be that easy can it?
No, it is not that easy. If volatility picks up and the carry trade loses favor then the carry will not be enough to make up for the huge loss in capital on the directional side of the trade. If you use too much leverage you will go kaboom and lose all your money.
There are a gazillion ways to measure volatility but some of the best ones are by using an actual volatility index. We have the VIX on the SP500 which is a surprisingly good measure of financial volatility and is suitable for currencies as well. But these days we have some volatility indexes from many of the investment banks which make it far easier to measure currency volatility and back test ideas.
If you are an active macro trader that is using the carry trade then you should incorporate a volatility filter. If you are not using the carry trade then you are missing out on a great way to diversify as well as deliver more consistent returns.
You don't just trade different asset classes but even different strategies within an asset class. If you trade bonds you will have some directional trades on, some spread trades, and some arbitrage trades. All of his is to further diversify your returns stream. You can do the same types of things in every asset class which makes your streams of returns very uncorrelated.
One area that is particularly suited to the macro trader is that of the currency markets. Yes, they trade currency crosses and build their own cross baskets but macro funds are also known to trade one strategy called the carry trade quite frequently.
The carry trade consists of going long a high yielding currency and going short a low yielding currency to fund the trade. You make money in two ways. One is if the initial trade is profitable if the higher yielding currency goes up relative to the low yielder. The other way to earn money is to make money off the carry, or the interest rate differential.
The carry trade is helped tremendously by the use of leverage. If you can earn four percent via the differential and then magnify that by four or five you will then bring your returns up to sixteen or twenty percent a year from the carry alone. If you juice it up ten times you will have a forty percent return. This sounds great on paper but it cant be that easy can it?
No, it is not that easy. If volatility picks up and the carry trade loses favor then the carry will not be enough to make up for the huge loss in capital on the directional side of the trade. If you use too much leverage you will go kaboom and lose all your money.
There are a gazillion ways to measure volatility but some of the best ones are by using an actual volatility index. We have the VIX on the SP500 which is a surprisingly good measure of financial volatility and is suitable for currencies as well. But these days we have some volatility indexes from many of the investment banks which make it far easier to measure currency volatility and back test ideas.
If you are an active macro trader that is using the carry trade then you should incorporate a volatility filter. If you are not using the carry trade then you are missing out on a great way to diversify as well as deliver more consistent returns.
About the Author:
If you need actionable trading ideas then check out The Macro Trader It is a weekly global macroadvisory publication with frequent intra-week updates for time-critical analysis and actionable trading ideas.
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