Back on March 20, 2007, TheFinancialWhiz.Com started an experiment of combining a basket of nine currencies versus the Chinese Yuan (see post). The goal of the basket was to generate positive interest payments from the long currency holdings, with a secondary goal of generating capital appreciation.

The portfolio, as of Saturday, January 5, 2008, has a Net Asset Value of $143,364.22, which represents a 43.36% gain over the initial $100,000 balance. The Net Asset Value is broken down into three components: Initial Investment, Unrealized Gains (Losses), and Interest Income. The below table shows the breakdown of the current portfolio:

Figure 1 provides a better illustration of the percentage of capital appreciation and interest income attributed to the Net Asset Value. Interest Income, the primary goal, represented 61.22% of the gain over the Initial Investment, and Capital Appreciation, the secondary goal, represented 37.32% of the gain over the Initial Investment.

Figure 1.

Over the nine-month test period, the Chinese Yuan Carry Trade Portfolio had a Sharpe Ratio of 1.3696. The inputs used to derive the Sharpe Ratio were a 48.61% annualized return, 5.00% risk-free rate, and a 31.84% annualized standard deviation.

The top performing position in the portfolio was the short USD/TRY (short US Dollar, long Turkish Lira) holding, which along with its superior interest rate, appreciated from 1.40636 to 1.16804, about a 17% gain over the nine-month test period. This 17% increase from capital appreciation was on top of the $5,101 received from interest payments (about 10.20% interest earned on the initial $50,000 position).

Obviously, the worst performer was the long USD/CNY (long US Dollar, short Chinese Yuan) position, which fell depreciated from 7.746 down to 7.2836, or a decline of 5.96%. However, this loss from currency movements is offset by a generous interest rate payment for holding the Chinese Yuan short, since it is a widely known fact that it is being manipulated stronger. After taking into account the interest payments received, the position is down approximately $11,946.13 or 2.38% on the initial $500,000 long USD/CNY position.

A question that has been asked many times is why the Chinese Yuan and not the Japanese Yen, the stereotypical carry trade choice. The answer for them is the fact that the Chinese Yuan is in a controlled appreciation, while the Yen can be very volatile at times. Over the test period if the USD/JPY was substituted for the USD/CNY position, the USD/JPY would have lost approximately 7.05%, but would have been partially offset by an approximate 3.22% positive interest carry, for a net loss of 3.83%. Combine the increase loss with the greater volatility of the Japanese Yen and the Sharpe Ratio drops much lower than that of the Chinese Yuan Carry Trade Basket.

Figure 2 charts the daily Net Asset Value of the Chinese Yuan Carry Trade Basket over the entire test period.

Figure 2.

The chart below shows a breakdown of interest payments per day on the account:

With the account generating approximately $173.166 per day, the portfolio will generate about $63,205.59 in interest per year, which is being generated on a portfolio with a leverage ratio of approximately 5 times the account balance. The leverage ratio is fairly conservative given that retail Forex accounts allow leverage up to 50 times the account balance. The low leverage ratio lowers the risk of a margin call on the currency account.

The results of the Chinese Yuan Carry Trade Basket experiment have been surprisingly positive and while past performance is not indicative of future performance, the generous amount of interest that an investor will receive will offset the majority of downdraws that this diversified portfolio might experience.

Supplemental Charts

USD/CNY - March 20, 2007 - January 5, 2007

USD/JPY - March 20, 2007 - January 5, 2007

USD/TRY - March 20, 2007 - January 5, 2007

Please note that this example is for educational purposes and uses a historical trade from April 2007

Another strategy utilized by investors is the Stock Collar. This strategy involves owning or purchasing 100 shares of a particular stock, buying a put option and selling a call option. An investor sells a call option to finance the “insurance” put option. While doing this does limit the downside, it also limits the upside potential. This strategy tends to be used less by money managers because of the possibility of missing a big positive move.

In Figure 4, the investor purchases 100 shares of Yahoo, Inc. (YHOO) on April 20, 2007, buys the July 2007 $25 put option, and sells the July 2007 $32.50 call option. From the breakdown of the trade in July 2007 at the maximum and minimum extremes, the positions could show a profit of 17.08% or a loss of 9.94%. This type of trade would be most suitable for trading a stock that an investor feels has a good probability of increasing in value, but about which he still holds some hesitations. The idea with this trade is to protect the position against strong negative moves, and instead of paying the put “insurance” premium out of pocket, the investor is simply financing that premium with a call sold for a premium. There are some money managers who use collars when trading indexes; they do this because the likelihood of an index increasing by 3% in a month is very unusual, but a drop of 5% or more is more likely.

A stock/option collar could have been used in the case of Martha Stewart. When she had received insider information that a drug was going to not be approved by the FDA, she then ordered her stockbroker to sell all of her Imclone shares. Although she was not guilty of insider trading, she was guilty of obstruction of justice, after lying to Federal investigators about her actions. Had she known that a news release was about to happen (and had not received the information from the CEO before news release), she could have purchased a collar or protective put to protect against the downside. She would have never run into the problem of selling the stock, had she used one of the options strategies introduced in this paper.

Figure 4

Please note that this example is for educational purposes and uses a historical trade from March 2007

A lesser-known strategy is the Protective Put strategy, which involves purchasing or holding a stock and buying a put option to protect against the downside. The strategy is the opposite of the Covered Call Strategy because the investor is limiting their downside and leaving the upside potential of the position. This type of protection does come at a cost, such as purchasing insurance against a loss; an individual must pay a premium in order to receive the protection. The amount of premium that an investor pays depends on the volatility within the individual stock, the higher the volatility of the stock, the more premium that an investor will have to pay for the “insurance”.

Figure 3 is a fictitious trade involving the purchasing or holding of 100 shares of Google, Inc (GOOG) on March 22, 2007. The reason for this hedge was Google planned to announce earnings after the bell on April 19, 2007, and to hedge against any downside risk the investor purchased a $470 put option, limiting the total risk of loss to $1,750 while maintaining the unlimited upside potential minus the $15.60 put option premium.

Figure 3

Please note that this example is for educational purposes and uses a historical trade from March 2007

Another way to play the income aspect of the Covered Call is through a strategy known as Cash-Secured Put Selling, which involves selling a put option, keeping the premium, and—if the option is exercised by the buyer—purchasing the 100 shares per contract. This might sound risky, but the idea is for the investor to keep enough cash in the account to purchase the shares should he receive an exercised notice. This strategy is ideal if used on a stock that an investor would not mind owning in their portfolio, should they receive an exercised notice.

In figure 2 below, the investor is taking a hypothetical trade in Cisco Systems (CSCO) on March 22, 2007. The investor sells the July 2007 $27.50 Put option at $1.42, which results in a cash premium received of $142 (representing a 5.44% return from the total cash requirements of $2,608). The trade is very similar to the Covered Call strategy and has the same Profit/Loss chart layout. The Cash-Secured Put Selling strategy is more appropriate on stocks that do not pay large dividends because, with it, the investor does not have the incentive to hold the shares to receive the dividend. Another nice feature of this strategy is the cash that the investor must keep on hand to secure the short put option can be invested in 90-Day T-Bills, which would provide the investor with some additional income. Another way an investor could utilize this approach is if he wanted to buy a stock at a lower price than what the stock is currently trading at. To do so the investor could decide to sell an in-the-money put option (which will most likely lead to the option being exercised). Therefore, instead of buying the stock outright, the investor would receive the premium today and as the option approaches expiration the investor would be required to purchase the underlying shares when the short option is exercised by the counter-party.

Please note that this example is for educational purposes and uses a historical trade from March 2007

The most popular options strategy among all investors today is Covered Call Writing. The basic idea of this strategy is to hold a stock with a near-term outlook that shows the stock will remain stagnant at its current price. In this situation, an investor could create a “synthetic” dividend by selling one call option and receiving the premium for every 100 shares of the stock that they own.

For example, Figure 1 below is a fictitious trade involving the purchasing or holding of AT&T (T) at $39.19 on March 22, 2007 and the selling of a $40 July 2007 Call Option, paying the investor a premium of $1.15 or $115 for the entire option. The figure also illustrates the amount of gain or loss at different stock prices. This analysis does not take into account the $.355 dividend paid in July, but if it were included, it would be an additional $35.50 at each profit/loss breakdown.

Figure 1
Covered Call Writing provides the investor the ability to create cash flow by selling options and keeping the premiums. In the example above, the selling of the option creates a “synthetic” dividend of 2.93% for a four month holding period, or an annualized ”synthetic” dividend of 8.79%, in addition to any actual cash dividends that the company pays on their shares. However, there are two main downsides to this strategy. The first is that keeping the money invested in a not-so-promising stock for an extended period leaves the investor open to losses from holding a losing security. The second drawback is that this strategy caps the upside that an investor can experience from holding the stock. If the security would experience a sudden growth, the investor would not benefit because he would have to sell at the strike price of the call option.

One of the most exciting financial instruments available comes in the form of derivatives. The versatility of derivatives, allows for many different investment goals to be reached. Derivatives are growing in popularity and are quickly emerging as an essential financial investment tool. One of those derivatives is Futures, which are a financial contract obligating the buyer to purchase an asset (or the seller to sell an asset), such as a physical commodity or a financial instrument, at a predetermined future date and price. Futures are most common among institutional investors and large firms because of the high risk that comes with trading the volatile futures market. Another growing derivative is Swaps, which is an exchange of streams of payments over time according to specified terms. Although both of these are growing derivative fields, this focus is solely on another type of derivative, options.

A stock option is a privilege sold by one party to another, which gives the buyer the right, but not the obligation, to buy (call) or sell (put) a stock at an agreed-upon price within a certain period or on a specific date. An option is a contract for 100 shares of an underlying security at a particular strike price, which is the price per share for which an option holder upon exercise of the option contract may purchase underlying stock. While the 100-share contract size seems quite small, it does limit the use of options in a portfolio to individuals and managers that have the purchasing power for at least 100 shares of a particular stock.

A common misconception with the option market is that it is very risky and volatile, capable of causing fortunes to erode in one swift blow. This, however, is due to the speculative aspects, to which only a small minority of traders is actually attracted. These two markets can give the trader the ability to minimize risk and to create lower volatility returns, which is the opposite effect of the commonly accepted opinions as mentioned above. In my paper, I will describe how investors can utilize options to manage risk and create predictable future returns.

Over the course of the next few posts, TheFinancialWhiz.Com will examine various options trading strategies that can be used by investors to lower the risk of a particular position or overall portfolio. The strategies that will be covered are:

• Covered Call Writing
• Cash Secured Put Writing
• Protective Put
• Stock Option Collar

For questions regarding any of the strategies or explanations of options strategies not covered, please feel free to comment or email me. Happy Trading!

Almost daily, I receive emails asking how a trader can profit from the Turkish Lira, many of whom are drawn to the high interest rate feature of the currency. It is easy to forget about the huge volatile moves that has plagued the currency since its re-release. To look for a safe hedge currency, I examined the available currencies of surrounding countries with economies that in the same development phase. The logical choice would have been a bordering country, but since there are few choices that offer enough liquidity, the closest country was Hungary.

Examining the following calculations of volatility and correlation, the two currencies appear to provide the necessary hedge that will allow traders to profit and at the same time sleep comfortable at night.

The correlation between the two pairs EUR/TRY and EUR/HUF was .87591 during the three-month period of August 1, 2007 to October 31, 2007. This is a significant positive correlation because the market was extremely volatile during the August carry trade unwinding. The fact that the two pairs exhibit a strong, positive correlation means that a trader can go short the EUR/TRY and long the EUR/HUF, and the movement of the two currency pairs, which hopefully will continue exhibiting a strong correlation, will move inversely.

The historic volatility is also significantly lowered when the hedge is in place. Over the volatile August carry trade unwind period, the TRY/HUF pair had an annual volatility calculation of 16.6552%, while the USD/TRY pair had a calculated annual volatility of 25.2925%. While not all times are as volatile as was experienced in August, looking at the August and September period combined, the volatility is still lower in the TRY/HUF pair than the USD/TRY pair, at 13.5576% and 17.6828% respectively.

There is a trade-off to hedging the Turkish Lira with the Hungarian Forint and that is the amount of interest paid on the hedge. With a long Turkish Lira, an investor is receiving 15.75% in interest per year, while with a short position in the Hungarian Forint will cost an investor 8% in interest payments per year, netting the investor a positive 7.75% interest rate spread.

The lower interest received from placing this hedge may not be to the liking of some investors, but the fact remains that the pair will be less affected by a potential carry trade unwind. It appears that the Turkish Lira at this time is ready for a short, sharp depreciation versus the Euro and US Dollar, as it has been treading water over the past three months. However, other emerging currencies can match up with the Turkish Lira and provide a decent hedge, but none can match the Hungarian Forint in terms of similar economic conditions, strong correlation, and an excellent positive interest rate spread.

Disclosure: The author currently holds a synthetic long TRY/HUF position (short EUR/TRY, long EUR/HUF)

Supplemental Charts and Spreadsheet:

Volatility Spreadsheet Download

August 1, 2007 - October 31, 2007 - TRY/HUF

August 1, 2007 - October 31, 2007 - USD/TRY

August 1, 2007 - October 31, 2007 - EUR/TRY

August 1, 2007 - October 31, 2007 - EUR/HUF

In my post “Follow The Financial Whiz: The Countdown Begins Going from College to Career,” I set a goal to obtain a job offer by my graduation date of December 16, 2007. I am proud to say that I have achieved that goal.

I was offered positions with two very respectable firms, and both opportunities would have allowed me to continue dealing with investments. I have decided to join the Pennsylvania State Employees’ Retirement System as a Junior Investment Analyst specializing in private equity and venture capital investments. I feel that this position will allow me to continue to expand my knowledge into some of the most fascinating areas of investing. The position has me moving to the Harrisburg, PA area where I will be looking to continue to grow as an individual and as a professional.

The job opportunity was the direct result of the successful 8-month internship that I completed with the retirement system back in 2006. I felt that this opportunity would provide me with a workplace where I feel comfortable as I already know a lot of the expectations and procedures.

The decision was not an easy one to make, and anyone who has been around me the past two weeks can attest to this. The next couple of weeks will consist of me transitioning from my home here in Indiana, PA to my new home in Harrisburg, PA where I hope to settle in after the New Year.

I hope to post some updates from time to time as to my progress in the transition period, along with some new trading ideas that I have been cooking up in my head over the past couple months.

Thanks for all of the support that you, the readers, have shown me over the past 4 months to get to this point.

Bryan

This is an update on the performance of the Chinese Yuan Carry Trade Basket. The experiment was started with a base of $100,000 on March 20, 2007. I have included the performance figures for both of the experiments that I have been running, although they are the same in composition, I have leveraged them differently.

Since Inception (5 times leveraged basket):

Increase (decrease) in Account Balance: $27,338.01
Increase (decrease) in Unrealized Gains: $20,811.01
Increase (decrease) in Net Asset Value: $48,148.52
Total Portfolio Value: $148,148.52 +48.15%

Since Inception (10 times leveraged basket):

Increase (decrease) in Account Balance: $54,675.02
Increase (decrease) in Unrealized Gains: $41,622.02
Increase (decrease) in Net Asset Value: $96,297.04
Total Portfolio Value: $196,297.04 +96.29%

As an update, each currency pair in this basket, minus the USD/CNY pair is showing an unrealized profit. The 10x leveraged currency basket yields about $347.41 in interest per day, representing about 126.8% in interest per year on the initial $100,000 investment. The increase in interest is due to the change in the Oanda interest rate for the USD/CNY pair, which currently pays 8.9% in interest for holding the pair long, which should be more than enough to pay for the risk of holding long a depreciating pair.

At this time, I am contemplating rebalancing the portfolio at the end of the year to bring the initial allocations back in line and taking profits on some positions that have moved very favorably over the past 8 1/2 months.

Sorry for the sparse updates about this portfolio in particular, but in two weeks, I should be able to devote more time to presenting and updating the strategies on this site.

This is an update on the performance of the Chinese Yuan Carry Trade Basket. The experiment was started with a base of $100,000 on March 20, 2007. I have included the performance figures for both of the experiments that I have been running, although they are the same in composition, I have leveraged them differently.

Since Inception (5 times leveraged basket):

Increase (decrease) in Account Balance: $11,019.70
Increase (decrease) in Unrealized Gains: $23,221.74
Increase (decrease) in Net Asset Value: $34,241.44
Total Portfolio Value: $134,241.44 +34.24%

Since Inception (10 times leveraged basket):

Increase (decrease) in Account Balance: $22,039.40
Increase (decrease) in Unrealized Gains: $46,443.47
Increase (decrease) in Net Asset Value: $68,482.87
Total Portfolio Value: $168,482.87 +68.48% +55.87%

In 17 days since the last update, the portfolio has increased by 12.61%, which has been due to the continued weakness in the US Dollar versus all major currencies.