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Monday, July 9, 2012

Guest post: Advanced forex trading strategies

Forex trading strategies
Carry trades borrow money in one currency then invest in another

By Sara Mackey

Advanced forex trading strategies can vary considerably from trader to trader, often depending on the sophistication of the trader and their dealing size.

The huge and highly liquid forex market lends itself to a number of different advanced trading strategies and styles. Two of those — triangular arbitrage and the carry trade — will be discussed further in the sections below.

Triangular arbitrage


Triangular arbitrage is a form of arbitrage often employed by professional cross rate forex traders. The triangular arbitrage trade consists of three transactions made in three different currency pairs that are preferably made as simultaneously as possible in order to avoid market risk.

The result of these three transactions — if correctly executed — should result in a net flat position and a locked in profit. Nevertheless, a credit risk always exists with third party transactions, and the timing of the transactions can also incur market risk that can be substantial in the volatile markets where such arbitrage opportunities are more common.

In essence, the arbitrage results in largely offsetting forex trades in the three currency pairs when market conditions allow for a net profit to be taken on the position. This opportunity generally occurs when market conditions are temporarily out of line.

The fact that one currency pair has a direct relationship with two other currency pairs makes up the market aberration which this technique exploits. The formula for this arbitrage consists of:

CC1/CC2 * CC3/CC1 = CC3/CC2

As described in the above formula, CC1 refers to the first currency pair, CC2 the second and CC3 the third. As trading in two active currency pairs heats up, the third currency pair may get out of line or “left behind”, therefore setting up an arbitrage opportunity.

An example of triangular arbitrage could involve the EURUSD, USDCHF and EURCHF currency pairs. While the first two currency pairs tend to be more active, an imbalance in the EURCHF rate can result in the arbitrage opportunity. The arbitrageur then takes on a position in the first two currency pairs, which will be offset by an inverse position in the third currency pair, thereby allowing for a risk free profit. 

The carry trade


Another advanced forex trading strategy involves the differences in the interest rates paid on currencies. Basically, the carry trade involves the purchase of a high interest currency funded by a currency which carries a low interest rate.

Holding currencies for more than one day earns interest, while being short a currency incurs an interest charge. The net of these two interest rates applied to the amount of days from tomorrow or spot value until the following value date is generally called the “rollover” and will have a trader earning or paying interest on positions carried for every day included in the rollover period.

Therefore, the rate of interest in the currency’s country of origin will determine the amount of interest earned or paid out. This can turn into a large sum if market conditions favor the interest bearing currency.   

An example of a recent popular carry trade is buying the AUDJPY currency pair. The rate paid on the Australian Dollar is 4.75%, while the amount of interest paid to borrow Japanese funds is 0.10%.

Accordingly, buying the currency pair will net the AUDJPY carry trader 4.65% in annual interest, as well as any market gains if the Australian Dollar appreciates versus the Japanese Yen.

 
About the author: Sara Mackey works for Forexfraud.com, a leading guide in the field of Forex trading.

Image license: US-PDGov

14 comments:

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