Explain How Futures Have Negative Carry and Why It Matters

Futures with negative carry are a type of futures contract that costs more to hold than it earns in interest or dividends.

This is because the interest rate on the margin account is typically lower than the interest rate earned on the underlying asset. For example, if a futures contract on a stock with a dividend yield of 4% is purchased, but the interest rate on the margin account is only 2%, the negative carry would be 2%.

As a result, futures traders often face a challenge in managing their trades, especially when holding positions for extended periods.

Consider reading: Carried Interest

Carry is a financial concept that involves borrowing at a low interest rate to invest in a higher-yielding asset, but in some cases, it can be a negative carry trade where the cost of holding the investment exceeds the yield.

Negative carry is a type of carry trade with a negative yield.

Investors are driven by the singular motive of generating returns, which can be obtained through dividends or interest income, but also through capital appreciation.

Capital appreciation is a powerful weapon to generate returns, and it's the primary motive behind negative carry trades.

Curious to learn more? Check out: Negative Yield to Maturity

Negative carry positions in futures can be extremely costly due to the ongoing costs associated with being in a negative carry position that can eat away at profits over time.

These costs can blow out losses much worse in a market that moves against your position, making it difficult to recover from significant losses.

Incorrect timing of trades can also lead to higher losses, especially in volatile and unpredictable markets where holding a position for too long without the expected price movement can result in large capital drain.

The risk of significant drawdowns or even margin calls increases when traders use leverage in their strategies, amplifying both negative carry costs and potential losses.

The potential for losses is magnified when the asset price fails to appreciate as expected, compounding losses with carrying costs incurred during the holding period.

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Negative carry positions can lead to significant losses, especially if the asset price doesn't move as expected.

The losses are compounded by the carrying costs incurred during the holding period, resulting in a more significant erosion of capital than anticipated.

In a short selling situation, the trader faces the double whammy of greater losses as stock prices rise and the ongoing charge for borrowing.

This can blow out losses much worse in a market that moves against your position.

Incorrect timing of a negative carry strategy can result in higher losses, especially in volatile and unpredictable markets.

Large capital drain can occur if the price movement one expects doesn't happen, and the position is held for too long.

The ongoing costs associated with being in a negative carry position can eat away at profits over time, making it difficult to offset the carrying costs with eventual profits.

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Futures contracts can be a complex and nuanced investment tool, and one of the key factors to consider is the cost of holding onto a contract. Storage costs are a primary component of negative carry in a contango market.

Storage costs can be substantial, and they vary depending on the commodity being stored. Insurance costs are another significant factor, as they protect the stored commodity from damage or loss.

The opportunity cost of holding onto a futures contract is also a major consideration. This is known as interest, and it represents the potential earnings that could be made by investing the money tied up in the commodity elsewhere.

Convenience yield is a more nuanced concept, representing the benefits gained from having the physical commodity readily available versus waiting for a futures contract to expire. This can be a significant factor, especially for traders who need to hold onto a commodity for an extended period.

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Negative carry strategies can be a valuable tool for traders, offering leverage and protection against market declines. They allow traders to amplify their exposure to market movement for small initial investments using strategies like short selling or purchasing deep out-of-the-money options.

Related reading: Stocks Futures Trading

By hedging with put options, traders can protect their long positions from market dips. This is particularly attractive for investors seeking low risk and stability in the long term.

Negative carry strategies also enable traders to continue holding positions in the face of uncertainty, positioning for future gains. For example, a trader with a bearish view on a high-yielding currency could long that currency by shorting it, despite the costs of keeping the position.

Here are some key strategies to consider:

These strategies can help traders achieve their financial objectives by carefully weighing the costs and potential rewards of negative carry trades.

Negative carry strategies offer a unique advantage to traders as a portfolio tool. They allow traders to amplify their exposure to market movement for small initial investments using strategies like short selling or purchasing deep out-of-the-money options.

One key benefit is leverage, which enables traders to generate outsized profits exceeding those of negative carry expense with even small changes in the underlying asset. This can be particularly attractive for investors seeking low risk and stability in the long term.

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Negative carry strategies also provide protection against market declines by allowing traders to hedge their positions. For example, buying put options on long positions can help protect against increased volatility.

Hedging costs may put a slight dent in returns in flat or rising markets, but they protect the downside on dips in the market. This makes negative carry strategies highly attractive for investors seeking low risk and stability.

By using negative carry strategies, traders can continue holding positions in the face of uncertainty and position for future gains. This requires carefully weighing the costs and potential rewards before using these strategies.

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Spread trading strategies can be used to reduce or potentially benefit from negative carry situations. This is done by simultaneously holding long and short positions in different contract months or related commodities.

One effective spread trading strategy is the calendar spread. By using a calendar spread, traders can potentially offset the negative carry costs associated with one leg of the trade.

Inter-commodity spreads can also be used to benefit from negative carry situations. By holding long and short positions in different commodities, traders can potentially reduce or eliminate the negative carry costs.

Using spread trading strategies can be a complex and nuanced approach, but it can be a powerful tool for traders looking to reduce or benefit from negative carry situations.

Contango and Backwardation can be a bit tricky to understand, but essentially, it's about the relationship between spot and futures prices.

In a contango market, futures prices are higher than spot prices, which can lead to a negative carry scenario. This means that the costs of carrying the physical commodity exceed the potential gains from rolling over the contracts.

The key to contango is that futures prices are higher than spot prices. This can be a problem for commodities futures traders who are trying to make a profit.

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In a backwardation market, futures prices are lower than spot prices, which can offer a positive carry opportunity. This is the opposite of contango, and it's a more desirable scenario for traders.

Commodities traders may enter into negative carry deals if they believe the income they generate will raise over time in excess of the costs and/or the capital appreciation will offset it.

Negative carry positions can be used for hedging purposes within a broader portfolio. By accepting a negative carry cost on one position, traders may be able to offset or reduce risks in other parts of their portfolio.

Here are some examples of how negative carry can be used for hedging:

Day traders are also impacted by negative carry due to its daily effects.

Negative carry positions can be used for hedging purposes within a broader portfolio. This allows traders to offset or reduce risks in other parts of their portfolio.

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By accepting a negative carry cost on one position, traders may be able to offset or reduce risks in other parts of their portfolio. This can be a useful strategy for managing risk.

Entering into put options trades can help reduce tail risk. This is one way traders use negative carry positions for hedging purposes.

Shorting stocks is another example of using negative carry positions to hedge against potential losses. This involves selling stocks that are expected to decline in value.

Having on a negative carry FX trade, such as long JPY against short Turkish lira, can also be used as an insurance policy against potential losses. This is particularly useful if other parts of the portfolio are expected to decline.

Motivated traders and investors are driven by a desire to profit from market fluctuations, which can be triggered by various events, including economic indicators and company announcements.

Fear of missing out (FOMO) can also be a strong motivator, as traders and investors don't want to miss out on potential gains.

Many traders and investors are risk-takers, willing to take on high-risk strategies in pursuit of higher returns.

A desire for diversification is another common motivation, as traders and investors seek to spread their investments across different asset classes to minimize risk.

Some traders and investors are also motivated by a need to hedge against potential losses, using strategies such as stop-loss orders to limit their exposure.

As a day trader, you need to be aware of the negative carry costs associated with holding positions overnight. Even small costs can accumulate over time, especially if you frequently hold positions overnight or engage in multiple day trades.

Negative carry costs can eat into your profits, making it harder to achieve your financial goals. This is because the cost of holding a position overnight exceeds any potential gains from that position.

You might favor trades with positive carry, which can help offset these costs. Knowing the carry implications of different currency pairs or assets is crucial for making informed trade selection decisions.

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To minimize negative carry costs, you might choose to close a position before the end of the trading day. This can help you avoid overnight financing charges associated with leveraged positions.

Day traders often use leverage, which can amplify both gains and losses. Be aware that these costs can add up quickly, even if you're not holding positions for extended periods.

Here are some key points to keep in mind:

To avoid negative carry in futures, it's essential to understand the concept of financing costs. Financing costs are the interest paid on borrowed money to purchase a futures contract.

First, you should avoid over-leveraging your account. As we learned earlier, excessive leverage can amplify losses, making it difficult to recover.

High-interest rates can also contribute to negative carry, so it's crucial to monitor market conditions. In a high-interest environment, the cost of borrowing money to purchase a futures contract can be substantial.

For more insights, see: Seller Carry Financing

Don't be tempted to hold onto a losing position in the hopes that the market will turn around. This can lead to further losses and increased negative carry.

Instead, consider using stop-loss orders to limit your potential losses. By setting a stop-loss order, you can automatically close a losing position and prevent further losses from accumulating.

Additionally, it's vital to keep an eye on your margin requirements. As we discussed earlier, margin requirements can increase rapidly in a volatile market, leading to further losses and negative carry.

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