Profiting From Carry Trade Candidates

With the introduction of the carry trade into the mainstream audience, yen currency pairs have become the speculator's pair du jour. Currency crosses like the GBP/JPY and NZD/JPY have been able to net small intraday - or even longer term - profits for the currency trader as speculation continues to support the bid tone. But how can one enter into a market that is already seemingly overheated? Even if a trader could, what would be a good price, and doesn't everything that goes up come down? The answer is easier and simpler than most believe. In this article we'll show you how to use carry trades to profit from overwhelming market momentum.

All About The Carry Trade
First, let's take a look at the carry trade. In short, the carry trade is used when an investor or speculator is attempting to capture the price appreciation or depreciation in a currency while also profiting on the interest differential. Using this strategy, a trader is essentially selling a currency that is offering a relatively low interest rate while buying a currency that is offering a higher interest rate. This way, the trader is able to profit from the differential of interest rates.

For example, taking one of the favored pairs in the market right now, let's take a look at the New Zealand dollar/Japanese yen currency pair. Here, a carry trader would borrow Japanese yen and then convert it into New Zealand dollars. After the conversion, the speculator would then buy a Kiwi bond for the corresponding amount, earning 8%. Therefore, the investor makes a 7.5% return on the interest alone after taking into account the 0.5% that is paid on the yen funds.

Now on the earning side of the trade, the investor is also hoping that the price will appreciate in order to make further gains on the transaction. In this case, anyone that has invested in the NZD/JPY trade has been able to reap plenty of benefits. For 2007, not only were traders able to benefit from a 7.5% return, they also benefit from a currency that has appreciated by 20.6% since the beginning of the year - a far cry from your ordinary U.S. Treasury bond. (For more on this strategy, see Currency Carry Trades Deliver.)

Flags and Pennants: Easy and Simple
With the currency rising the way it has, how can a trader really capture market profits in the bull market? One such formation that has proved to be a great setup may be the all too familiar: flag and/pennant formations. This has been especially useful in carry currency crosses such as British pound/Japanese yen and New Zealand dollar/Japanese yen. Both formations are used in similar capacities; they are great short-term tools that can be applied to capture nothing but continuations in the foreign exchange market. They are both even more applicable when the market, especially in the case of carry trade currencies, has been trading higher and higher in every session. (For more insight, read Analyzing Chart Patterns: Flags and Pennants.)

To get a better sense of how this works, let's quickly review the differences between a flag and a pennant:

* A flag formation is a charting pattern that is indicative of consolidation following an upward surge in price. The name is attributed to the fact that it resembles an actual flag with a downward-sloping body (due to price consolidation) and a visually evident post. Targets are also very reliable in flag formations. Traders who use this technical pattern will reference the distance from the bottom of the post (significant support level) to the top. Subsequently, when the price breaks the upper trendline of the flag, the distance of the post will more often than not be equivalent to the next level of resistance.

* A pennant formation is similar to the flag formation - it differs only in the form of consolidation. Instead of a body of consolidation that moves in the opposite direction of the post (as in the case of a flag), the pennant's body is simply a symmetrical triangle. Although pennants have been known to slope downward as well, the textbook formation has also been noted as a symmetrical triangle, hence the name.

Trade Setup
Let's take a look at a real-life example using the British pound/U.S. dollar in July 2007. Here, a 60-minute short-term chart offers a great opportunity in the GBP/USD in Figure 1. After convincingly breaking through resistance at the pivotal 2.0200 trendline, the underlying currency proceeds to top out at 2.0361 and consolidates. Forming a flag technical pattern, we note that the post is 160 pips in length and apply it when the currency breaks through the top trendline at 2.0330. As you can see, the estimate rings true as the pound sterling gains against the U.S. dollar far above market targets and tops out at 2.0544 before consolidating again.

Source: FX Trek Intellicharts
Figure 1: A perfect flag formation in the GBP/USD

Flag and Pennants in Carry Candidates
Similar setups are seen in the cross currency pairs, giving the trader plenty of opportunities in the currency market, with or without dollar exposure. (For more on these pairs see, Make the Currency Cross Your Boss.) Taking another market favorite, the British pound/Japanese yen, let's take a look at how this method can be applied to the chart.

In the short-term 60-minute chart in Figure 2, a typically long flag formation is coming around in the GBP/JPY currency pair. In order to establish the formation initially, it is recommended that the chartist draw the topside trendline first. This rule is a must as an initial drawing of the bottom trendline may lead to varying interpretations. Once the initial downward-sloping trendline is drawn, the bottom is a simple duplicate. Here, the trader will make sure to note a touch by the session bodies rather than the wicks in verifying the formation as true. This is to isolate only true price action and not volatility or common "noise" that may occur in the short term.

In Figure 2, the bottom trendline has been pushed slightly higher to incorporate the bodies rather than the wicks. Next, we measure the post. In this case, referencing a major support level at 245.69, we calculate the differential with the top of the move at 248.93. As a result, the distance between the two prices is 324 pips. Theoretically, this will place our ultimate target at 251.74 on a break of the trendline at 248.50.

Source: FX Trek Intellicharts
Figure 2: An extended flag formation offers plenty of opportunity.

Trading Rules
When placing the entry, always make sure of two things:

1. The trade is on the side of carry. This means that the speculator is always buying the higher interest rate currency. In this case, the trade is going long pound sterling and gaining 5.25%.

2. Always place the buy entry after the candle close. Applying a buy order after the break of the top trendline ensures that the trendline has been broken. Placing the entry before the close above the trendline may subject the order to being hit on possible market noise above the resistance barrier. This may leave the trader in an unfavorable position as consolidation continues.

Taking into account both rules, we place the entry on the close or slightly below, at 248.77. Risk takers will likely hold the carry trade until the full move has been completed. However, a more conservative strategy, and one that works more often than not, involves placing an initial target at the halfway mark. Taking into consideration the break at 248.50 and half of the full forecast of 324 pips, initial targets should be set at 250.12 with the corresponding stop five pips below the session low.

Step by Step
Now let's take a look at a step by step process that will allow traders to enter on the carry trade momentum in the market. Figure 3 shows a great opportunity in the New Zealand dollar/Japanese yen cross pair. Following the complete downturn that occurred July 9 - July11, 2007, a visual burst can be seen by chartists as bidders take the currency higher over the next 48 hours, establishing a temporary top at Point A.

Source: FX Trek Intellicharts
Figure 3: Following A Sharp Decline, NZDJPY Vaults Higher Off Of Support

Now we set the stage (Figure 4):

1. After consolidation, draw the topside trendline first, completing the formation with the duplicate bottom trendline giving the chartist the flag boundaries.
2. On a sign of a trendline break, measure the distance from the bottom of the post to the top. In this instance, the bottom support of the post is 93.81 with the top at 95.74. This gives the trader a potential for 193 pips on the trade after a break of the top trendline.
3. Once there is a confirmed break of the trendline, place the entry that is at the session close or lower of the finished candle. In this case, the break occurs approximately at 95.40 with the entry being placed at that session's close of 95.46 (Point C). Subsequently, a corresponding stop is placed five pips below the session low of 95.37. Ultimately, the position is well within normal risk parameters as it is risking 14 pips to make 193 pips.
4. Set initial and full targets. With the full move estimated at 193 pips, we get a partial distance of 96 pips (193 pips / 2). As a result, the initial target is set for 96.42 (Point B).
5. Set contingent trailing stops. Once the initial target is achieved, the overall position should be reduced by half with the rest being protected by a trailing stop set at the entry price (or break-even). This will allow for further gains while protecting against adverse moves against whatever is left. Longer term strategies will hold to the entry price as the ultimate stop, promoting a worst-case scenario of break-even.

Incidentally, the initial target is achieved right before a slight retracement in the NZD/JPY currency in the example. Subsequently, the position remains on target for further gains as it continues to trade above the entry price.

Source: FX Trek Intellicharts
Figure 4: Trade setups in the NZD/JPY

Conclusion
Flags and pennants can accurately support profitable trading in the currency markets by assisting in the capture of overwhelming market momentum. In addition, applying strict money management rules and using a trained and disciplined eye, a trader can boost returns while helping the overall portfolio in capitalizing on the yield offered through the interest rate differential. Ultimately, sticking to those two tenets of market price and yield, FX investors can't go wrong being long on carry.

By Richard Lee,
Access Investopedia's Forex Advisor FREE Report - The 5 Things That Move The Currency Market

Richard Lee is a currency strategist at Forex Capital Markets LLC. Employing both fundamental models and technical analysis applications, Richard contributes regularly to DailyFX and Bloomberg. He has extensive experience in trading the spot currency markets, options and futures. Before joining the research group, Richard traded FX, equity and equity derivatives for a private equity consortium. Richard graduated from Pennsylvania State University with a Bachelor of Arts in economics and a Bachelor of Science in French with an emphasis in international business.