Carry Trades and the Weak Hands Theory
January 2nd, 2007 by Justin
Everyone talks about the smart money and the dumb money. These terms tend to be a bit silly if only because they require circular definitions. Smart money is “smart” because it makes money, but if it stops making money, it becomes dumb money. The terms, however, imply that those making money rarely lose money, which is not the case. More accurate definitions, then, should encompass the players involved. Banks, pension funds, most mutual funds, and large Hedge funds make up the smart money, so-called because over the long run their strategies have been profitable. Retail investors, day traders, and highly speculative hedge and mutual funds are what I’d call dumb money, because while they might be wildly profitable in the short term, their long-term profits are far from assured.
Which brings me to my point: any healthy trend will have inevitable periods of weakness. These “shake out” the weak hands, which means those who
A. Got involved in the trend too late, and are therefore losing money even when the trend is not in question.
B. Lack sufficient capital, and are subjecting themselves to too much risk by being in the trend during a correction.
C. Are intraday or short-term traders playing off of momentum, and therefore not looking for long-terms gains consistent with the trend.
D. Are overleveraged and therefore unable to sustain the correction (This amounts to the same thing as point B in essence).
This occurred in a major way earlier this year in the NZD/JPY. What was before a healthy carry trade–where traders could earn over 35% annually on 5 to 1 leverage, became a bloodbath when the Bank of Japan began talking about removing excess liquidity from the banking system and raising interest rates (see the two points I’ve circled). However, once all of these short-term players were out of the picture, the trend resumed, and nearly all of the 2000 pips that were lost were recovered.
What does this mean? It means that traders put themselves in a great position when they successfully identify a healthy trend, as anyone may have with this pair. However, if their account size is too small to handle a major correction (see points B and D above), or if their timing does not coincide with the major trend (points A and C) then they will bear the brunt of any correction.
For those with adequate capital and the patience to wait out a long-term trend, however, the profits can be substantial. On interest alone–i.e., assuming that the position is opened and closed at the same price–clients can earn over 35% on this and many other carry trade pairs with minimal leverage.
