Starting with a small deposit of $69.10, supporting a short position of 210 USD/TRY, my intention is to increase the value of my carry positions each year in such a way that the initial interest income of $1.05 per month grows to approximately $1000 per month over the course of 10 years. The simplest way of doing this would simply be to let the interest income of (initially) 6% support an additional 100% in position size, but this would require leverage of about 16:1 for the entire period which is far too risky. The key to the success of this strategy will be mitigation of risk through the following methods:

1. Diversification: Initially I'll be building positions in the Turkish Lira, the Hungarian Forint, and the South African Rand. This helps to lower the risk that a destabilizing event in one part of the world will move the entire carry portfolio into a margin call.

2. Front loading of leverage: I will be increasing the size of the positions more quickly during the early years when the amounts involved are low. Using the highest leverage during this period means that any additional margin deposits necessary due to adverse moves will be affordable. There are details on this below.

3. Trading around the core position: When the position size is smaller than its projected size at a given time, I will add to the position more quickly when it is at a loss and more slowly when it is in profit. Conversely, when the position size is larger than projected, I will reduce it more quickly when it is profit, and more slowly when it is at a loss. This contrarian approach will tend to move my average entry price in a favorable direction over time. There is a simple formula for doing this, details of which are below.

The basic idea here is that for each month during the 10 year period, I have a specific goal percentage by which I plan to increase the position size. But instead of keeping this percentage increase constant, I start with a high amount and reduce it to zero over the 10 year period. Let's say I begin with a 12% increase during the first month and reduce that by a tenth of a percent per month, so it becomes 0% at the end of 10 years. The resulting margin percentage and monthly income stream would look like this:

This is actually the growth schedule that I'll be attempting to achieve. Here is the actual monthly projection table behind the chart:

Obviously these projections are based on simplified assumptions such as the interest differential between all carry currencies and the USD remaining at 6% which certainly won't happen. If anything however, I expect those differentials to increase as the world emerges from recession and begins to raise rates to ward off inflation. However, the projection serves to illustrate the benefits of starting with a high rate of increase and reducing the rate over time.

Note that the margin value (deposit/position) declines to a low of about 6% at about 3-1/2 years into the projection. This is the point at which the risk of a margin call resulting from an adverse move is greatest. However, this occurs early enough in the buildup that the deposit sizes are fairly low, so it would be very affordable for me to substantially increase the deposit size if I had to during this period. I can stave off a margin call with only a few hundred dollars as opposed to having to come up with much larger amounts in later years. During the later years however, I'll be increasing the position size more slowly, so that the deposit increase due to interest payments becomes a larger and larger percentage of the position size. This increases my margin, decreases my leverage, and thus my risk.

Finally, I'd like to illustrate the profound effect that the choice of the starting percentage increase has on the overall projections. Starting at 12% per month is about right for my goal, but what if I started at 24% instead? Or what if I started at only 6%? Below are two more charts showing the effects of these changes. Note that my ending monthly income would be $600,000 if I started increasing the position size at 24% in the first month! However, the risk is quite a bit larger as well, with margin dipping down into the 3% range. At that point a 3% move in the USD would wipe me out. The other extreme is illustrated by the chart showing what happens when we start at an increase of just 6%. In this case, I'd be bringing in a whopping $35 per month at the end of 10 years which hardly seems worth the effort.

I think that covers the concept of front loaded leverage, so let's move on to the method of trading around the core positions. On any given date during the 10 year buildup period, there is a specific projected position size, which can be determined from the growth schedule that I discussed above. For example, on the first day of the 10th month, the total value of my carry positions should be $559. It's a fairly simple exercise to interpolate what the value should be on any day during the month as well.

The simplest growth method then would simply be to add to the positions periodically so as to keep to the schedule. However, I will be attempting to take advantage of price fluctuations to get a better average entry price over time. The way to do this is to add to the positions more quickly during periods when they are at a loss, because prices are more favorable then. During periods when the positions are at a profit, I will be adding more slowly. Conversely, if I am attempting to reduce my position sizes down to the projected value, I'll do this more quickly when they are at a profit, and more slowly when they are at a loss. The formula for accomplishing this is:

Order = (deposit/equity)*(projected position) - (actual position)

As an example, suppose I have an actual position size of $200 and a projected position size of $250 dollars at a given point in time. My goal is to increase my position size by $50. But suppose I'm deep in profitable territory, meaning that prices are not very favorable now. If my cash deposit is $90 and my equity is $100, the formula above would yield:

($90/$100)*$250 - $200 = $225 - $200 = $25

So in this situation I would actually place an order to add only an additional $25 to my position at these prices; not $50. Note that in extreme situations the direction of the order can actually be reversed. If the size of my cash base (deposit) in the above example were only $70, we would have:

($70/$100)*$250 - $200 = $175 - $200 = -$25

In this case I would actually be reducing my position size even further from its projected size on this date because taking profits is so lucrative. Over time of course the increasing projected position size will force me to keep adding to the position over the long term in order to keep to the growth schedule, but in the short term I hope to accumulate some additional trading profits with this method.

I will not be placing market orders for this purpose. Instead, I will be placing stop orders "behind" the price as it moves in a given direction. For example, if I have a sell order to place, I would place it only when the daily bars are making higher lows, and place the order behind those lows, moving it up behind the price in order to lock in a better price when it finally fills.

That's the complete carry trade strategy. The table at the top of the home page provides a summary of the current situation, showing the key variables required for the calculation of the order sizes. For examples of the strategy in operation, just follow my blog entries on the main page. Stay tuned, and keep pipping up!

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