Business-Insider

As any investor who has been profiting from the carry trade during the past few years knows, the Japanese yen (JPY) has been quite volatile lately---which has ripped a lot of profits out of carry traders' pockets. A few days ago, I posted a video about a strategy I've used (the covered carry trade) to allow me to stay in my carry trades and collect my rollover interest.

Click here to see the previous article: http://www.pfxglobal.com/index.php?o...399&Itemid=188

Since then, I've received a few questions via MyPFX regarding Covered Carry Trades, and I wanted to answer them here so everyone else could see the discussion.

Question #1: "In the example you gave on the GBPJPY trade, the strike price for the covered call is 217.00. If we were to set our stop loss in the GBP/JPY trade at 217.00, wouldn't we be in a risk free situation while still collecting the interest diferential for the trade?"

Answer #1: Setting a stop loss at 217.00 would eliminate much of your risk, but it wouldn't be risk free. Here's the reason. If you get stopped out of your spot trade, you are still short the call option. If the pair turns around and moves higher after you get stopped out, you can lose money on the option.

Imagine the pair drops, stops you out at 217.00, and then turns around and moves back up to 218.00. Because you are still short a call option with a strike at 217.00, you would be down 100 pips.

Question #2: "I was very interested with you covered carry trade video. My question is around how to manage the deal if you are close to the point when you could make a loss. In your example, this would be around the 216.70 level. Would the easiest way to do this be to just stop yourself out on the spot position and buy back the call? In your experience, what is the best way to limit your risk?"

Answer #2: You can exit your call option when you get stopped out of, or otherwise exit, your spot trade when the price drops down to your breakeven point. This is usually the best thing to do. However, you will have to buy your call option back for whatever it is worth at the time.

Even though your call option will not have any intrinsic value if the currency price drops below the strike price of the option, it will still have extrinsic (time) value. This could be anywhere from 10 to 150 pips---depending on what your expiration date is. Buying this option back will result in a loss on the trade, but a small loss.

You can see that there is some risk involved in this trade if it goes against you (sorry, no free lunches yet). You will certainly limit your downside losses and give yourself a nice cushion to stay in the trade for as long as possible, but things can still move against you.

To see the remaining 3 questions and my answers to them, click here: http://www.pfxglobal.com/index.php?o...632&Itemid=188
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