- Published on Tuesday, 12 June 2012 08:03
- Written by Zachary Scheidt, Editor, Hedge Fund Strategist & Velocity Trader
- Hits: 458
Do you know the difference between a "positive carry" and a "negative carry" trade?
The terms might sound a bit technical, but the concept could represent the difference between making money -- or slowly losing money in the hopes of "hitting the big one."
Hedge fund traders almost always group their trades into two categories:
- Positive Carry trades are positions that actually pay you while you wait for the ultimate outcome. A good example of this would be a dividend stock that generates income for you while you hold the stock. Ultimately, your goal is to see the stock move up sharply, but getting an extra 3% while you wait isn't too bad.
- Negative Carry trades are positions that lose value over time or require additional capital while you wait for the trade to work out. Buying puts or calls by themselves is often a negative carry trade because the time decay works against you. For these trades, you have to have proper timing so your profits offset the cost of holding the position over time.
Most traders only know of a few conservative ways of trading with positive carry. The dividend stock example is easy to understand, but you're not likely to get rich holding a stock that pays 3% annually and may increase 5% over a year (if you're lucky).
Another conservative positive carry idea is to buy stock and sell calls against the position. In this scenario, we can generate some nice income (sometimes as much as 50% annualized), but we don't have a chance of hitting a grand slam.
We'll talk about covered calls a bit more next week, but today I want to tell you about a much more aggressive positive carry trade.
In mid-April I noticed that small-cap stocks were looking particularly vulnerable.
Although blue-chip stocks were still making new recovery highs, the small cap iShares Russell 2000 Index (IWM:NYSE) had stalled out and was ready to roll over. I immediately set up a positive-carry options position for my Hedge Fund Strategist subscribers.
I won't bore you with the actual trade details, but I'll tell you that we put together a bearish structured option position that paid us to put the position on our books, and was profitable even if the market didn't fall right away. (If you want to see the details, take a no-risk trial of the service and read the April 12 post.)
The trade was set up so that we had a VERY good chance of making a small amount of money (positive carry), a very small chance of losing a limited amount of money (careful risk management), and a decent shot at making a LOT of money (if small caps fell sharply).
This position was very simple and can be set up in an IRA or any brokerage account enabled for option trading.
Two months later, we are still holding the position and we are sitting on modest profits.
I can't guarantee we will hit the BIG profits from this trade (we still need IWM to fall a bit farther), but I can tell you I am happy to be collecting a modest profit while still having a shot at scoring a huge win.
This is just another example of how hedge fund managers engineer their trading approach to stack the odds in their favor rather than simply making a directional bet and "hoping" that their timing is correct.
To your trading success!