3 Yen Trades that Make Money

0
This post looks at three real and proven strategies that you can use to trade Japanese yen. Yen has some unique attributes that set it apart from other currencies. It is the third most traded currency after the US dollar and the euro. USD/JPY is the second most liquid pair after EUR/USD according to latest BIS figures of turnover.
Three yen (JPY) strategies
Three yen (JPY) strategies © forexop

Event trade

The yen is highly sensitive to the general risk outlook. When risk is perceived to be high, the yen appreciates. When it’s low it depreciates. The yen is what’s called a primary safe haven currency.

This seems inconsistent at first since the Japanese economy has been mired in a low growth, deflationary cycle for the past two decades.

Why the yen is a safe haven

The contradiction can be understood as follows: Japan has very large foreign reserves – in fact it’s a major creditor to the rest of the world. This means it is less dependent on the whims of international bond markets where credit can be shifted away from a country very quickly.

Japan also has a trade surplus to the rest of the world. Both of these factors, along with its political stability contribute to the yen being favored in times of uncertainty.

Risk=Uncertainty

The graph below shows the Japanese yen index versus the VIX. The VIX is a widely used measure of risk. The correlation isn’t perfect but you can see a general pattern. In most case yen is higher when risk is on the rise and lower when risk is falling. There were a few exceptions such as the late 1990’s when the Asian crises were in full flow.

Figure 1: Yen vs risk: Comparison of the yen index and the VIX
Figure 1: Yen vs risk: Comparison of the yen index and the VIX © forexop

This strategy is ideally used where you expect uncertainty, and “implied risk” to rise very quickly. The trading rule is simply:

  • Buy yen when risk is increasing
  • Sell yen when risk is decreasing

Uncertainty will rise precipitously after a surprise event. For example, after Brexit and Trump’s win in the US election we saw this yen effect.  There was a large appreciation of the yen while markets digested the consequences.

These kinds of event trades often have excellent risk adjust returns. This is because markets have already priced in for a certain scenario; for example, Brexit not happening, and therefore the risk premium is relatively underpriced. When you buy yen for example, betting on the alternative, the chances of yen falling dramatically if you are wrong is quite low.

For example see Figure 2. The left box shows USD/JPY during Brexit. The last upward leg happened as markets were “certain” of a win for remain. If remain had won at this point we may have seen a modest upward rally and then possibly a downward correction as positions closed.

In fact the dollar fell 7.2% as the yen appreciated. GBP/JPY fell by nearly 17% in one day and by 22% over the following few weeks.

Figure 2: Example surprise events and how yen reacts
Figure 2: Example surprise events and how yen reacts © forexop

Ideally, you’ll enter the trade before the event happens and implied risk rises. But it’s still possible to trade these post-event if you’re quick.

Using options

Buying or selling yen pairs is one way to trade event risk. But another way is through yen options. You can use a call or put option to trade the long or short side respectively. Options have some powerful advantages in these scenarios:

  • Your position won’t be “stopped out” by whipsaw markets as the news breaks
  • Similarly, you won’t be stopped out by gaping spreads
  • You can use high gearing for very low probability/high payoff trades
  • Your loss is limited to the option’s price – it can never go negative.

Theme trades

A theme trade won’t give you an overnight jackpot like an event trade will, but it is a good strategy for the medium to long term.

The yen has experienced some prolonged trends in the past. Not just against the US dollar, but against currencies like the AUD, CAD, GBP the euro, metals and oil.

The inert Japanese economy makes it a good play against other currencies during economic cycles. The graphs below show yen versus the euro, the Canadian and Australian dollar. All of which are more geared to the economic upcycle, increasing activity, rising interest rates, rising commodity prices, and decreasing risk aversion.

The yen on the other hand is inversely related to commodity prices. It tends to decline with rising oil prices, and increase in times of falling oil costs. Of course the relationship isn’t perfect because there are many other factors that affect exchange rates – but it’s certainly noticeable. See Figure 4.

The last couple of years have seen huge falls in commodity prices, and this has benefited the yen. At the time of writing, oil prices are on the rise again, and that’s pressuring yen.

These trends depend on an outlook and some long term predictions. Some examples of theme trades are:

Yen depreciation: The Bank of Japan is employing quantitative easing as it tries to inject more inflation. This will probably continue to some extent until it manages to re-inflate the economy. This puts continual downward pressure on the yen. If you’re short yen, you benefit from positive interest carry (see below).

Ranges: The Bank of Japan has suggested that they would like to see USD/JPY stay within the range 110 to 120. Even if they don’t adjust policy to maintain this range, the very fact of the central bank saying that the currency is overvalued/undervalued can be a self-fulfilling prophesy. Even if policy change is be needed to maintain the level going forward.  You can try to anticipate these announcements when USD/JPY moves beyond the preferred range.

Trends: As I said above, yen has seen some powerful trends as it adjusts to economic activity elsewhere in the world. Japan’s demographics, monetary policy and economy mean the disparity will be there in the foreseeable future. Therefore new trends are likely to develop in similar ways as they have in the past with new economic cycles.

Figure 3: Long term yen theme trade: Example EURJPY
Figure 3: Long term yen theme trade: Example EURJPY © forexop
Figure 4: Yen’s relationship to oil price
Figure 4: Yen’s relationship to oil price © forexop

Yen Carry Trade

The yen has had very low interest rates since the mid 1990’s. This has made it a choice for funding what’s called the carry trade. A carry trade is a strategy where an investor borrows a low interest paying currency, and exchanges it for a high interest paying currency. There’s an enormous variety of ways to create carry trades, including:

  • Spot currency
  • Currency futures
  • Currency forwards
  • Interest rate swaps and derivatives

Ultimately, all boil down to the same thing – exploiting interest rate differentials.

Carry trading can be highly profitable when markets are benign and volatility is low. Hedge funds and private investors use the carry trade as a staple strategy. They’ll often use leverage to magnify relatively small interest differentials.

The yen has had a low, and even declining interest rate for the last two decades. Over the same time most western economies have gone through several economic cycles with rising and falling interest rates. This makes the yen a natural choice for carry trade funding.

The other side of the yen carry trade would typically be a high yield currency of a major economy. Choices at the moment would be either the Australian dollar or New Zealand dollar. See here for latest rates.

Carry trade hedging

The attractiveness of the carry trade can change suddenly. This happens as interest rate outlooks change and economies change. That can result in rapid unwinding or liquidation of positions. Carry trade unwinding usually results in a powerful correction with yen surging as those traders with short yen positions have to buy them back very quickly. See Figure 1.

The easiest way to protect against this is to hold out of the money call options on yen. If a sudden rise happens, the call option will cover the loss.

In low volatility markets, out of the money yen call options are very cheap. These are a worthwhile insurance against heavy losses even though they will reduce carry trade profits a bit.

ebook bundle cover
Trader's eBook Value Bundle

eBook value set for the classic trading strategies: Grid trading, scalping and carry trading. All ebooks contain worked examples with clear explanations. Learn to avoid the pitfalls that most new traders fall into.

Join 11,000+ other traders and subscribe to Forexop's newsletter. It's free to join and you'll get updates directly to your inbox. Just add your email address below.
About the Author

Steve Connell has spent over 17 years working in the finance sector as a trader/market maker and strategist. Over that time he’s worked for several global banks and hedge funds. Steve has a unique insight into a range of financial markets from foreign exchange, commodities to options and futures.

No Comments

Leave a Reply