For the past few years both New Zealand and Australia have benefited handsomely from rising commodity prices and exports to China.

In late August 2004 the Reserve Bank of New Zealand (RBNZ) raised rates yet again — the fifth .25 point hike in 2004 — because the prospect of an overheating economy was seen as a greater potential problem than a rapid rise in interest rates. Despite the fact China’s growth was moderating, the RBNZ believed dampening speculation in the housing sector was its first priority.

Meanwhile, Australia had paused a monetary tightening cycle while awaiting more data on housing, retail sales and inflation. The result was the sharp decrease in the AUD/NZD. While this chart certainly does not look like a “buy” from a technical perspective, there were broader reasons to believe the currency pair could be putting in a bottom.

Macroeconomic theory supports the idea the aggressive rate hikes by the RBNZ would soon filter through New Zealand’s economy, impacting growth. With a typical interest rate “lag factor” of eight to 12 months, fall 2004 was shaping up to be a potential adjustment period for the AUD/NZD rate. Although some key economic data still had not yet been released in early October, the market was beginning to bet the pace of economic growth was starting to wane — a viewpoint that was ultimately reflected in the charts.

After many weeks of relentless price declines, the daily and weekly charts confirmed a bottom could be in place as defined by the stochastic oscillator. On the second-to-last candle in , the AUD/NZD rate made a higher low and closed above the open while the stochastic indicator made a higher low. A similar pattern appeared(Another factor that led to the conclusion the AUD/NZD was due to turn up was the fact that the daily chart was completing the fifth wave of an Elliott Wave pattern.) A long trade was initiated on the next day’s open at 1.0580, with a stop at 1.0520, which was 10 pips below the most recent low.

As expected, either the rapid rise in interest rates in New Zealand or some conclusion to the tightening process would be the catalyst needed to propel AUD/NZD higher. The catalyst materialized on Oct. 27 when the RBNZ indicated its monetary tightening phase was nearing completion.

The new landscape now clearly favored Australia, as it indicated rate hikes may not be done. The currency pair quickly traded back through its 50-day exponential moving average (EMA) before touching the 200-day EMA at 1.1030. On Nov. 9, the New Zealand Finance Minister indicated he was “uncomfortable with the current value of the NZD” and the currency was likely nearing a top and would face headwinds going forward. The result was a nice push back above the 200-day EMA. (As of Nov. 10, the trade was still open, with a revised stop loss of 1.0790.)

The Euro/British pound (EUR/GBP) rate provides another example of the insights macro factors contribute to a trade. This scenario, which also resulted in a long position, is somewhat similar to the AUD/NZD example. In this case, we were looking for a contraction in the rate differential between the European Union and Britain.

Britain had been aggressively raising rates through 2004 in an effort, as Bank of England (BOE) president Eddie George stated, “to stem the tide in the rapid increase in housing prices.” The BOE was determined to nip this problem in the bud rather than let a full scale economic bubble develop and burst, thereby throwing cold water on consumer spending, which could send the economy into a recession.

It was at this time the European Central Bank (ECB) had halted rate cuts, as the economy was beginning to enjoy the benefits of relaxed monetary policy. The inevitable conclusion was rates would rise on the European continent but not in Britain. The prevailing carry trade environment (a carry trade consists of buying the currency with the higher interest rate vs. the currency with the lower interest rate in order to capture yield) was drawing to a close and a possible interest rate “catch-up” in Europe vs. UK was in store. See “The short term British pound/Japanese yen carry trade” on p. 22 for more information.

The charts, of course, were already bearing this out, but again, a tangible macro story allows one to really stay with a trade knowing what logically should unfold.

It shows the EUR/GBP rate. In this case, there was a straightforward pullback within an uptrend.

Pullbacks within clearly established trends offer a clear edge vs. trying to pick bottoms; trends tend to continue after periods of consolidation at support levels.

The EUR/GBP moved higher in the subsequent weeks. Continued comments from the Bank of England signaled rate hikes were all but done, while the ECB left the door open for further hikes.

The dollar’s continued weakness also played a role in pushing this trade higher. With Asian central banks intervening to protect their currencies from appreciating vs. the dollar, the euro bore the brunt of the dollar weakness because the ECB rarely conducts direct open market intervention in the euro.

While most individual traders doubt the usefulness of fundamental or macroeconomic analysis, many of the largest players in the FX market rely heavily on it.

Although the conclusions you draw from macro or technical analysis might ultimately be similar, having a tangible rationale for entering the market, as opposed to simply obeying a line on a chart, can do a great deal to bolster confidence in your trading and deepen your understanding of how foreign exchange works.

We’ll review some of the key macro factors in the FX markets and see how they can provide insight into potential market moves. Then we’ll look at some recent trades illustrating how to combine macro research with technical patterns.

Although there are any number of fundamental factors at work in the FX market at a given time, we will address the following three: interest rate differentials, commodity prices and the level of risk aversion among traders at a given time. They are easy to understand and illustrate in the market.

After a robust 2003, the Canadian dollar pulled back vs. the U.S. dollar in the first four months of 2004 before pushing to new relative highs in September. The U.S. dollar/Canadian dollar (USD/CAD) rate on Oct. 20 broke down below the shorter-term support level (around 1.25) it had established earlier in the month.
Although there is speculation in some circles the Canadian dollar stands a good chance of continuing
to gain against the dollar — the recent price thrust and rate hikes by the Bank of Canada would seem to support that position — there are several reasons for traders to be mindful of the potential for a correction, if not a larger reversal, in the not-too-distant future.

Technical traders will watch how the 1.25 level in the USD/CAD acts as resistance after being penetrated as support. If another meaningful down move is in the wings, technicians will look for this level to turn back any upside correction, and will not want to see it exceeded significantly or for very long. A move above the Oct. 13 spike high of 1.2688 would at least temporarily invalidate the downtrend scenario, but most chart watchers will be nervous about a strong or sustained move up to 1.2575-1.2600. Testing a pattern modeled after the four-day sell-off that occurred from Oct. 20 to Oct. 25 showed a slightly bullish short-term tendency after such moves.
It shows the percentage returns (measured from closing prices) for the first 15 days after a four-day down move greater than 2.5 percent when the three most recent closes were lower than the preceding closes.

There were 14 previous patterns that met these criteria since 1998, the most recent being March 29 and 30, 2004. Except for days 8-10, the average moves were marginally higher (day 3 had a negative median return), and all days but two (days 2 and 3) had positive returns at least half the time. Also, although days 8-10 had negative average returns, their median returns were positive — which
implies an “outlier,” or exceptionally large, non-representative value has distorted the average — and the percentage of positive returns on that day were 71 percent. (However, the mild upside bias turned slightly negative in days 18-20 after the pattern, not shown).

A 120-minute chart of price action through 11:30 a.m. ET on Oct. 27, shows the USD/CAD
having established a third progressively lower short-term support level, but was trading slightly higher
on the day. In addition, Commodity Futures Trading Commission Commitment of Traders data shows small speculator long positions at one of the highest levels of the past 12 years, which is typically viewed as a contrarian signal because of the pattern for small traders to be on the wrong side of the market near turning points (see “Canada looking toppy”).

The U.S presidential election on Nov. 2 might also have a role to play. “Elections and the U.S. dollar“ shows a long-standing tendency for U.S. dollar to rally after elections.

And of course, there is little in the markets that crude oil cannot impact these days. Crude’s historic strength this year has bolstered Canada’s (an oil exporter) economic bottom line this year, and any significant sell-off will affect the CAD.

In short, traders who have most recently jumped (or re-jumped) on the Canadian dollar bull bandwagon could be in for a rough ride if any combination of these factors align in the coming weeks.

On Oct. 18, 2004, a currency trader who noticed the EuroFX had been in a range between roughly 1.2450 and 1.2250 for a few weeks and believed the economic releases of the next two weeks would cause the euro to break out of this range could have created the following position: a long strangle in weekly options, purchasing the Friday expiring (Oct. 29) 1.2300 puts and 1.2500 calls for a combined 98 ticks($1,225). Breakeven at expiration would be above 1.2598 or below 1.2202, not including commission and fees.

The slight upside bias to the strike prices reflects the previous day’s bullish move up to 1.2500.

The cost difference between these weekly expiring options and the monthly options that expire in the first week of November would be considerable. A trader wanting to buy the monthly November 1.2500 calls and the 1.2300 puts would have to pay a combined cost of 143 ticks ($1,787.50). Breakeven at expiration would be 1.2643 or 1.2157, not including commission and fees. If you believed the employment report was going to move the market within the next day but were unsure about the next three weeks, there would be no reason to pay for the added time value of the November options.

For short-term traders who want to trade imminent market events, weekly currency future options provide the opportunity to buy options cheaper and more accurately target specific time windows.

Weekly options are useful in several types of trading situations. First, say you recognize the Swiss franc (SF) has been in a trading range for the first three weeks of November, and the fourth week of November does not have any major economic releases likely to move the market out of this range. In such a situation, you might want to sell a strangle in fourth-week expiring options.

A short strangle consists of selling a call option with a strike price at the high end of the most recent week’s range and selling a put with a strike price at the low end of the range with the expectation the market will remain between those price levels until expiration. Selling “naked” premium this way can be very risky, but for experienced traders who can monitor the market very closely and whose research indicates a positive probability for the expected low-volatility price action, the risk is manageable. If the
market remains within the range and the options expire worthless, you keep the premium you collected from the short options.

If you established the short strangle using comparable monthly options, you would collect more premium (because these options are further from expiration and have more time value). However, these options would notdecay as fast as the weekly options because they have more time value than the weekly options.

A long strangle could be used if you think a currency might make a significant price move during a particular week. For example, say the Canadian dollar (CD) has also been in a trading range for the first three weeks of November, but you think economic numbers published in the fourth week of November could really move the currency. You’re not bullish or bearish, but you believe these numbers are going to cause the Canadian dollar to break out of this range. In this case, you could buy a fourth-week expiring strangle, buying calls at the top end of the third week’s range and buying puts at the bottom end of the range.

The risk on a long strangle is limited to the purchase price of the options, plus commissions and fees. (However, if one of the options expires in the money, you can end up holding a long or a short futures position, which would leave you with unlimited risk.) The third trade scenario is based on the idea the Canadian dollar will break out of its range to the downside during the fourth week of November, except that you’re already long Canadian dollar futures. In this situation, you could sell fourth-week Canadian dollar call options to hedge the futures position.

What advantages do weekly currency options offer over regular monthly options? Options that expire every four to five weeks can be difficult to incorporate in short-term trading strategies. Weekly currency options allow you to tailor strategies — especially those that incorporate both futures and options — to a shorter time frame, rather than a monthly outlook. Traders sometimes fall into the trap of using long-term macro approaches to trade short-term price movement. If you want to capitalize on short-term
trends, it’s logical to use short-term tools.

Each trading week many economic numbers are released in the United States and overseas that affect the value of the dollar and foreign currencies. If you believe a specific currency, such as the EuroFX (EC), is going to react to a particular number, you might want to position yourself accordingly in the market. However, if you think this move is going to occur in a specific week, you may be caught in the predicament of paying for the time value of a longer-dated monthly option. With a weekly option, you can tailor your trade to the specific time window that contains the opportunity.

Each week presents a new opportunity to speculate or hedge underlying currency futures with options. One technique that can be used in a variety of trading situations is to structure positions according to the most recent weekly trading range, to take advantage of expected price action within or outside this range.

Trying to stay on top of economic numbers and volatile markets requires knowing which markets
and tools are the most appropriate in a given situation. In the currency futures market, the weekly expiring options (“serial options”) offered by the Chicago Mercantile Exchange allow traders to more effectively take advantage of short-term trading opportunities.

Weekly currency options expire on the Friday of the designated week and can be traded one month out from the current week. For example, during the second week of November, you would be able to trade the options expiring on Friday, Dec. 10, which is the second Friday in December. Regular currency options expire the first Friday of each month and can be traded up to a year in the future.

Combining a trend-following technique along with a stochastic enables you to make sure you are buying pullbacks in uptrends, selling rallies in downtrends and taking advantage of the temporary extremes during sideways trading range affairs.

These two indicators, the Donchian channels and the stochastic, work well together in this regard.

To turn this concept into a workable trading plan you need to review the history of your preferred currency markets to determine the best points to exit losing trades, take profits and ensure any unique attributes are accounted for in your approach. For example, it could turn out a 70-period channel is too long or there is a more appropriate lookback period for the stochastic oscillator.

However, there is a problem with using a 14-period Donchian channel and a 14-period stochastic. Identical lookback periods do not make sense if you’re trying to determine both the long-term trend and shorter-term overbought and oversold points to signal entry points.

Trial and error led to adopting a 70- period Donchian channel as the trend filter, with the simple rule that if the two channel lines are stretching apart, the market is trending. If the channel lines are contracting, the market is in a trading range.

When the market is in a trading range, the stochastic can be used to buy oversold points and sell overbought points. When the market is trending, take only those stochastic signals in the direction of the trend.

It shows the same price action, with 70-bar Donchian channel lines added. Beginning in December 2000 the difference between the channel lines leveled off and the market entered into a trading range. In February 2001 the two lines contracted (the lower line was static while the upper line declined) and the stochastic indicator prematurely signaled a bottom in March. However, the indicator gave another crossover buy signal in June, just ahead of the July lows. There was a crossover sell signal just before the September 2001 peak.

During June 2002, price began to push the upper Donchian channel line higher while the lower channel line moved sideways. This stretch signaled that the market was moving into an uptrend. In this situation, you would look for the stochastic to pull back and give a buy signal. Because the market is
trending it is not necessary for the stochastic to fall all the way to 20 or lower; if it does, however, it is still a valid buy signal if the channel lines are stretching. For example, in October and December 2002 and April 2003, %K crossed above %D at opportune moments to enter the bull trend during pullbacks. In September 2003 and April 2004, the stochastic did, in fact, drop below 20 when generating %K/%D crossover buy signals.

Donchian channels are lines that delineate the highest high and lowest low over a specific lookback period. They are named after Richard Donchian, who tested and popularized certain breakout trend-following techniques in the 1960s.

The blue lines surrounding price in are 14-bar Donchian channels, which show the highest 14-week high and lowest 14-week low at any given point. Because the stochastic indicator measures the most recent closing price relative to the range of the last 14 weeks, high readings occur when price
hits the upper Donchian channel. Similarly, low stochastic readings ccur when price tags the lower Donchian channel. If the market starts to trend upward, as it did in April 2002, the upper Donchian channel line will move up more quickly than the lower channel line. This expansion or stretching of the two channel lines, which means the market is making repeated higher highs (look at April and November 2002, for example), is an indication of a trend.

The stochastic is designed to indicate when a market is overbought or oversold. A stochastic displays two lines, %K and %D. The %K line is calculated by finding the highest and lowest point in a trading period and then finding where the current close is in relation to that trading range; %D is a moving average of %K. We’ll be using the following stochastic parameters: 14 period for the basic lookback period and three days for both of the moving average smoothings (a “14,3,3” stochastic). For more information on this indicator, please see the sidebar, “Stochastic basics.”

It is a weekly chart of the Euro/U.S. dollar currency pair (EUR/USD), along with the 14-period
stochastic oscillator. It shows how during trading ranges (such as the one from June 2000 to January 2002) high stochastic readings tend to coincide with price highs while low stochastic readings tend to accompany price bottoms.

A traditional overbought (sell) signal occurs when the stochastic is above 80 and the %K line crosses below the %D line, which happened in both January and September 2001. These events coincided with market peaks. Conversely, the traditional oversold buy signal occurs when the %K line crosses above the %D line when the stochastic is below 20. The first buy signal occurred in May 2000.

There are times when the stochastic buy signal crossover may repeat before the final price low occurs. For example, a buy signal occurred in September 2000, but it turned out to be early, as the market subsequently made a lower low. In early November, the stochastic flashed a second buy signal.

This same pattern of back-to-back buy signals occurred in early April 2001. The second buy signal was two weeks ahead of the final low in the first week of July 2001. The next stochastic buy crossover occurred in early December, but the trend made one more new low and, again, another buy signal occurred in February 2002. Although our eyes are naturally drawn to the signals that work well in the trading range, the subsequent uptrending period highlights an attribute of the stochastic
oscillator that many people overlook: When a market trends, the stochastic can, in fact, confirm the trend by failing to reach the extreme levels counter to the trend. In other words, if the market is in an uptrend, the stochastic will reach the overbought level but fail to make oversold readings. An uptrend
is, in a way, a persistent overbought state.

The stochastic pushed into overbought territory in April 2002 and never declined below 20 again until August 2003. The market simply continued to zigzag in an uptrend; the upward shift in the stochastic readings (where the %K crossed back above %D when the indicator was at relatively high levels, such as occurred in November 2002) was a sign of strength.

The adage “the trend is your friend” is perhaps more applicable to currencies than any other market. The fundamental factors driving the currency market tend to change slowly, leading to sustained trends or sideways market conditions that can last for a year or more.

Recognizing this, a logical way to try to trade currencies is to first determine the trend, and then use techniques to trade in concert with that trend — that is, find points when the market is pulling back in an uptrend so you buy at a relatively low level.

The approach outlined here combines the Donchian channel, which determines the trend, with the stochastic oscillator, which is used to time the trade entries.

Although many chartists believe they can identify WRBs when they see them on a chart, such bars if they are to have any predictive value or trading application — must meet strict criteria that can be analyzed objectively. Consistency is key.

We used a 60-day look-back period to determine what constitutes a WRB in the EUR/USD. This period spans approximately three months and represents what would typically be considered an intermediate term perspective of market action.

Instead of using a nominal multiplier to define wide range — i.e., 1.5 or 2 times the 60-day average range — we ranked each bar’s daily range relative to the preceding 60 bars. For example, if today’s range is .0119 and it has a percentile rank of .95, it means 95 percent of the previous 60 bars, or 57 bars, had ranges smaller than .0119.

We initially used a threshold of .80 or higher — that is, all bars with ranges in the 80th percentile or higher of their 60-day comparison period. We also analyzed the performance following WRBs with a percentile rank of .90 or higher.

Because carry trades are least profitable when investors are highly risk averse, traders who already have carry trades must stay abreast of the risk environment and prepare for when it changes.

Investors’ willingness to make risky trades can change dramatically from one moment to the next. Often such large shifts are caused by significant global events. When investor risk aversion does rise quickly, the result is generally a large capital inflow into low-interest rate, “safe-haven” currencies.

Such conditions can set the stage for carry trades to lose money.

For example, in the summer of 1998 the Japanese yen appreciated against the dollar by more than 20 percent in two months, mainly because of the Russian debt crisis and the LTCM hedge-fund bailout. Similarly, just after the Sept. 11, 2001, terrorist attacks, the Swiss franc rose by more than 7 percent against the dollar over a 10-day period.

The leveraged carry trade strategy is still very popular in the currency markets. By properly assessing the risk environment, traders can increase the probability of successfully executing the carry trade strategy.

While risk aversion is one of the most important things to consider before making a carry trade, it is not the only one. Here are some additional issues to take into account.

Low interest rate currency appreciation: Even if market participants are in risk-seeking mode, there are factors that can lead to a rally in the currency with the lower interest rate. When the low interest rate currency in a carry trade (the currency being sold) appreciates, it negatively affects the profitability of the carry trade.

For example, geopolitical risks or fears of terrorism tend to have a positive affect on the Swiss franc, which is widely considered the “safe-haven” currency.

In Japan, although interest rates are low, increased optimism about the Japanese economy has recently led to an increase in the Japanese stock market. Increased investor demand for Japanese stocks and currency has caused the yen to appreciate, and this yen appreciation negatively affects the profitability of carry trades such as the Australian dollar (high interest rate) vs. Japanese yen.

Trade balances: Trade balances (the difference between a country’s imports and exports) can also affect the profitability of a carry trade. When investors have low risk aversion, capital will typically flow from the low interest rate paying currency to the high interest rate paying currency.

However, this does not always happen. To understand why, consider that even though Japan currently pays historically low interest rates, there is strong demand for the Japanese yen. Although this can be attributed partially to the country’s recent recovery, a more important factor is Japan’s huge trade surplus. There is strong foreign demand for Japanese goods electronics, cars, etc. As a result, although the country offers low rates of return, Japan attracts trade flows into the yen. The point is that even when investors have low risk aversion, large trade imbalances can cause a low interest rate currency to appreciate.

Time-horizon: In general, a carry trade is a long-term strategy. Before entering into a carry trade, an investor should be willing to commit to a time horizon of at least six months. This commitment helps to make sure the trade will not be affected by the “noise” of shorter-term currency price movements.

Carry trades generally are most profitable when investors as a whole have a very specific attitude toward risk.

Psychology drives the markets and people’s moods tend to change over time. Sometimes they may feel more daring and willing to take chances, other times they may be more timid and conservative. Investors, as a group, are no different. Sometimes they are willing to make relatively high risk investments, other times they are more fearful and seek safer assets. When investors as a whole are willing to assume risk, we say they have low risk aversion, or, in other words, they are comfortable taking risk. When investors are drawn to more conservative investments and are less willing to take on risk, we say they have high risk aversion.

Carry trades are most profitable when investors have low risk aversion, which makes sense when you consider what a carry trade involves. When buying a currency with a high interest rate, the investor is taking a risk — there is uncertainty about whether the country’s economy will continue to perform well and be able to pay high interest rates.

Countries with better growth prospects can afford to pay higher interest rates on the money that is invested in them, but there is always a chance something might change. Ultimately, investors must be willing to take this chance.

If investors as a whole were not willing to take on this risk, then capital would never move from one country to another, and the carry-trade opportunity would not exist.

Now, a 4-percent annualized yield may not sound very attractive, but when you factor in leverage, the profits are noticeably higher (as are the risks). Although many FX firms offer up to 200:1 leverage, we will look at a more conservative example that employs 20:1 leverage.

Let’s say you have $5,000 to invest and decide to put $1,000 of that into a carry trade. The original 4.75 percent yield would earn you $47.50 over the course of the year or approximately $0.13 per day. With 20:1 leverage, the buying power of your $1,000 becomes $20,000. Interest then becomes $950 per year or $2.64 per day on the original investment — a return of 95 percent.

Now here is where we insert the caution statement: This scenario works only if the underlying values of the currencies do not move — which of course is not possible. Currency values fluctuate every second. Therefore, using higher leverage also means you incur the possibility of larger losses. For example, instead of a 10-pip (or point) fluctuation in the euro-U.S. dollar rate (EUR/USD) representing $1, 20:1 leverage magnifies it to $20 — and currencies will fluctuate dramatically.

Between September 2003 and July 2004, the Australian dollar strengthened nearly 15 percent against the U.S. dollar. If you factor in the currency appreciation and interest rate return on leverage, the profits can be sizeable. However, 15 percent depreciation could have just as easily occurred, which would significantly hurt a leveraged trade.

Because most traders engaging in this type of strategy are looking to earn both yield and the appreciation of the currency pairs, the next question is, how do you determine the type of environment in which carry trades will perform well?

Traders looking to “earn carry” will buy a high-yielding currency while simultaneously selling a low yielding currency. Carry trades are profitable because an investor is able to earn the difference in interest (the spread) between the two currencies as well as, ideally, capital appreciation. It lists the interest rates of several major countries as of Sept. 22.

The reason this trade is so popular is because it’s not limited to speculators. Imagine you are an investor in Switzerland who is earning an interest rate of 0.75-percent per year on your bank deposit denominated in Swiss francs (CHF). At the same time, a bank in Australia is offering 5.25 percent per year on a deposit denominated in Australian dollars (AUD). Seeing that interest rates are much higher at the Australian bank, wouldn’t you want to convert your Swiss francs into Australian dollars?

Large investors who are able to move money freely across borders will take advantage of higher yields offered abroad. By trading their deposit of Swiss francs paying 0.75 percent for a deposit of Australian dollars paying 5.25 percent, what these investors have effectively done is “sell” their Swiss franc deposit, and “buy” an Australian dollar deposit.

After this transaction they now own an Australian dollar deposit that pays 5.25 percent in interest per year — 4.50 percent more than the Swiss franc deposit. This is a carry trade.

The net effect of millions of people doing this transaction is that capital flows out of Switzerland and into Australia as investors take their Swiss francs and trade them for Australian dollars. Australia attracts more capital because of the higher rates it offers.

This capital inflow increases the value of the currency. Aside from earning the 4.50 percent interest rate differential, traders engaging in such unhedged carry trades are also hoping, as in this example, their Australian dollar deposits appreciate in value against the Swiss franc.

Let’s look at another example. Assume the British pound (GBP) offers an interest rate of 4.75 percent, while the Swiss franc offers an interest rate of 0.75 percent. To execute the carry trade, an investor buys the British pound and sells the Swiss franc — or, buys the GBP/CHF currency pair. In doing so, he or she can earn a profit of 4 percent (4.75 percent in interest earned minus 0.75 percent in interest paid), as long as the exchange rate between the British pound and Swiss franc remains stable.

Just as markets that offer the highest returns will attract the most volume, so, too, in the world of international capital flows, nations that offer the highest interest rates will generally attract the most investment and create the most demand for their currencies.

The “carry trade” is a forex strategy based on this reality. Although it is particularly popular among global macro hedge funds, it is actually very simple to understand and execute.

Carry trades involve buying (or lending) a currency with a high interest rate and selling (or borrowing) a currency with a low interest rate. With lackluster equity market performance and progressively lower yields from the U.S. bond market as a result of interest rate cuts by the U.S. Federal Reserve, this strategy’s popularity surged in 2002. As money piled into carry trades, unhedged traders enjoyed earning yield and capital appreciation.

If executed correctly, an investor can earn a high return without taking on excessive risk. However, the chances of loss are great if you do not understand how, why and when carry trades work best.

The trade intensity in the Asian–European overlap period is far lower than in any other session because of the slow trading during the Asian morning. Of course, the time period surveyed is relatively smaller, as well.

With trading extremely thin during these hours, risk-tolerant traders can take a two-hour nap and risk averse traders can spend the time positioning themselves for a breakout move at the European or U.S. open.