What Is Reverse Carry Trade?
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A reverse carry trade is a trading strategy where an investor sells a futures contract at a lower price and simultaneously purchases the underlying asset at a higher price. This strategy is typically employed when the investor believes that the price of the asset will decline in the future, aiming to profit from the convergence of futures and spot prices.
How Reverse Carry Trade Works
- Sell Futures at Lower Price: The investor initiates the trade by selling futures contracts for the asset at a lower price than the current market price.
- Buy Underlying Asset: At the same time, the investor purchases the actual asset (e.g., physical commodities or stocks) at a higher price in the spot market.
- Anticipate Price Decline: The core strategy hinges on the expectation that the price of the asset will decline before the futures contract expires. As the price drops, the value of the short position in futures increases while the long position in the underlying asset decreases, creating a potential profit opportunity.
Example
Imagine an investor believes that copper prices will fall in the coming weeks. They sell copper futures at $3 per pound while simultaneously buying copper in the spot market for $3.20 per pound. If the price of copper declines to $2.80 per pound before the futures contract expires, they can repurchase the futures at the lower price and sell their physical copper at the spot price, generating a profit.
Risks Associated
Market Risk
If the expected price decline does not materialize or if the asset price increases instead, the investor could incur significant losses.
Basis Risk
Changes in the basis (difference between futures and spot prices) can also affect profitability. If the basis widens against the trader, losses may accumulate.
Conclusion
Reverse carry trade is a speculative strategy that seeks to capitalize on anticipated price declines in assets. It involves selling futures contracts at lower prices while buying the underlying asset at higher prices, aiming to profit from convergence when prices decrease over time. However, it carries risks associated with market fluctuations and basis changes.