Carry Trade

Did you know that you can actually still make money in forex without doing anything? Yep! You just have to keep your fingers crossed that price stays the same for a long period of time.

What is the Carry Trade?

Did you know there is a trading strategy that can make money if price stayed exactly the same for long periods of time?

Well, there is and it’s one the most popular ways of making money by many of the biggest and baddest money manager mamajamas in the financial universe!

It’s called the “Carry Trade“.

“I’m tired of carrying this!”

What is a Carry Trade?

A carry trade involves borrowing or selling a financial instrument with a low interest rate, then using it to purchase a financial instrument with a higher interest rate. While you are paying the low interest rate on the financial instrument you borrowed/sold, you are collecting higher interest on the financial instrument you purchased.

So your profit is the money you collect from the interest rate differential.

Carry Trade Example:

Let’s say you go to a bank and borrow $10,000.

Their lending fee is 1% of the $10,000 every year.

With that borrowed money, you turn around and purchase a $10,000 bond that pays 5% a year.

What’s your profit?

Anyone?

You got it! It’s 4% a year! The difference between interest rates! By now you’re probably thinking, “That doesn’t sound as exciting or profitable as catching swings in the market.”

However, when you apply it to the spot forex market, with its higher leverage and daily interest payments, sitting back and watching your account grow daily can get pretty sexy.

To give you an idea, a 3% interest rate differential becomes 60% annual interest a year on an account that is 20 times leveraged!

Leveraged Carry Trade Example:

Let’s say you borrow $1,000,000 at an interest rate of 1%.

The bank won’t just lend a million bucks to anybody though. It requires cash collateral from you: $10,000.

You’ll get it back once you pay back the money.

Your loan is approved so fill up your backpack with cash.

Then you turn around, walk across the street to another bank and deposit the $1,000,000 in a savings account that pays 5% a year.

A year passes. What’s your profit?

You earned $50,000 in interest from the bond ($1,000,000 * .05).

You paid $10,000 in interest ($1,000,000 * .01).

So your net profit is $40,000.

With a measly $10,000, you earned $40,000! 

That’s a 400% return! In this section, we will discuss how carry trades work, when they will work, and when they will NOT work.

We will also tackle risk aversion (WTH is that?!?

Don’t worry, like we said, we’ll be talking more about it later).

What is a Currency Carry Trade?

In the forex market, currencies are traded in pairs (for example, if you buy USD/CHF, you are actually buying the U.S. dollar and selling Swiss francs at the same time).

You pay interest on the currency position you SELL and collect interest on the currency position you BUY.. What makes the carry trade special in the spot forex market is that interest payments happen every trading day based on your position.

Technically, all positions are closed at the end of the day in the spot forex market. You just don’t see it happen if you hold a position to the next day.

Brokers close and reopen your position, and then they debit/credit you the overnight interest rate difference between the two currencies.

This is the cost of “carrying” (also known as “rolling over“) a position to the next day. The amount of leverage available from forex brokers has made the carry trade very popular in the spot forex market.

Most forex trading is margin based, meaning you only have to put up a small amount of the position and you broker will put up the rest. Many brokers ask as little as 1% or 2% of a position.

Currency Carry Trade Example

Let’s take a look at a generic example to show how awesome this can be.

For this example, we’ll take a look at Joe the Newbie Forex Trader.

It’s Joe’s birthday and his grandparents, being the sweet and generous people they are, give him $10,000. Schweeeet!

Instead of going out and blowing his birthday present on video games and posters of bubble gum pop stars, he decides to save it for a rainy day.

Joe goes to the local bank to open up a savings account and the bank manager tells him, “Joe, your savings account will pay 1% a year on your account balance. Isn’t that fantastic?” Joe pauses and thinks to himself, “At 1%, my $10,000 will earn me $100 in a year.”

“Man, that sucks!”

Joe, being the smart guy he is, has been studying BabyPips.com’s School of Pipsology and knows of a better way to invest his money.

So, Joe kindly responds to the bank manager, “Thank you sir, but I think I’ll invest my money somewhere else.”

Joe has been demo trading several systems (including the carry trade) for over a year, so he has a pretty good understanding of how forex trading works.

He opens up a real account, deposits his $10,000 birthday gift, and puts his plan into action.

Joe finds a currency pair whose interest rate differential is +5% a year and he purchases $100,000 worth of that pair. Since his broker only requires a 1% deposit of the position, they hold $1,000 in margin (100:1 leverage).

So, Joe now controls $100,000 worth of a currency pair that is receiving 5% a year in interest.

What will happen to Joe’s account if he does nothing for a year?

Well, here are 3 possibilities. Let’s take a look at each one:

1. Currency position loses value. The currency pair Joe buys drops like a rock in value. If the loss brings the account down to the amount set aside for margin, then the position is closed and all that’s left in the account is the margin – $1000.
2. The pair ends up at the same exchange rate at the end of the year. In this case, Joe did not gain or lose any value on his position, but he collected 5% interest on the $100,000 position. That means on interest alone, Joe made $5,000 off of his $10,000 account. That’s a 50% gain! Sweet!
3. Currency position gains value. Joe’s pair shoots up like a rocket! So, not only does Joe collect at least $5,000 in interest on his position, but he also takes home any gains! That would be a nice present to himself for his next birthday!

Because of 100:1 leverage, Joe has the potential to earn around 50% a year from his initial $10,000.

Here is an example of a currency pair that offers a 4.40% differential rate based on interest rates in September 2010:

If you buy AUD/JPY and held it for a year, you earn a “positive carry” of +4.40%.

Of course, if you sell AUD/JPY, it works the opposite way:

If you sold AUD/JPY and held it for a year, you would earn a “negative carry” of -4.40%.

Again, this is a generic example of how the carry trade works.

Any questions on the concept? No? We knew you could catch on quick!

Now it’s time to move on to the most important part of this lesson: Carry Trade Risk.

Know When Carry Trades Work and When They Don’t

When Do Carry Trades Work?

Carry trades work best when investors feel risky and optimistic enough to buy high-yielding currencies and sell lower-yielding currencies.

It’s kinda like an optimist who sees the glass half full. While the current situation might not be ideal, he is hopeful that things will get better.

The same goes for carry trade. Economic conditions may not be good, but the outlook of the buying currency does need to be positive.

If the outlook of a country’s economy looks as good as Angelina Jolie or Brad Pitt, then chances are that the country’s central bank will have to raise interest rates in order to control inflation. This is good for the carry trade because a higher interest rate means a bigger interest rate differential.

When Do Carry Trades NOT Work?

On the other hand, if a country’s economic prospects aren’t looking too good, then nobody will be prepared to take on the currency.

Especially if the market thinks the central bank will have to lower interest rates to help their economy.

To put it simply, carry trades work best when investors have low risk aversion.

Carry trades do not work well when risk aversion is HIGH (i.e. selling higher-yielding currencies and buying back lower-yielding currencies).

When risk aversion is high, investors are less likely to take risky ventures.

Let’s put this into perspective.

Let’s say economic conditions are tough, and the country is currently undergoing a recession. What do you think your next door neighbor would do with his money?

Your neighbor would probably choose a low-paying yet safe investment then put it somewhere else. It doesn’t matter if the return is low as long as long as the investment is a “sure thing.”

Finding yield is not the priority anymore. preserving principal is.

This makes sense because this allows your neighbor to have a fallback plan in the event that things go bad, like if he loses his job.

In forex jargon, your neighbor is said to have a high level of risk aversion. The psychology of big investors isn’t that much different from your next door neighbor.

When economic conditions are uncertain, investors tend to put their investments in safe haven currencies that offer low interest rates like the U.S. dollar and the Japanese yen.

This is the polar opposite of carry trade. This inflow of capital towards safe assets causes currencies with low interest to appreciate against those with high interest.

Carry Trade Criteria and Risk

Carry Trade Criteria

It’s pretty simple to find a suitable pair to do a carry trade. Look for two things:

1. Find a high interest differential.
2. Find a pair that has been stable or in an uptrend in favor of the higher-yielding currency. This gives you the ability to stay in the trade AS LONG AS POSSIBLE and profit off the interest rate differential.

Pretty simple, huh? Let’s take a real life example of the carry trade in action:

This is a weekly chart of AUD/JPY. Up until recently, the Bank of Japan has maintained a “Zero Interest Rate Policy” (currently, the interest rate stands at 0.10%).

Also known as ZIRP. With the Reserve Bank of Australia touting one of the higher interest rates among the major currencies (4.50% in the chart example), many traders have flocked to this pair (one of the factors creating a nice little uptrend in the pair).

From the start of 2009 to early 2010, this pair moved from a price of 55.50 to 88.00 – that’s 3,250 pips!

If you couple that with interest payments from the interest rate differential of the two currencies, this pair has been a nice long term play for many investors and traders able to weather the volatile up and down movements of the currency market.

Of course, economic and political factors are changing the world daily.

Interest rates and interest rate differentials between currencies may change as well, bringing popular carry trades (such as the yen carry trade) out of favor with investors.

Carry Trade Risk

Because you are a very smart trader, you already know what the first question you should ask before entering a trade is right?

“What is my risk?”

Correct! Before entering a trade you must ALWAYS assess your max risk and whether or not it is acceptable according to your risk management rules.

In the example at the start of the lesson with Joe the Newbie Forex Trader, his maximum risk would have been $9,000. His position would be automatically closed out once his losses hit $9,000.

Eh?

That doesn’t sound very good, does it? Remember, this is the worst possible scenario and Joe is a newbie, so he hasn’t fully appreciated the value of stop losses.

When doing a carry trade, you can still limit your losses like a regular directional trade.

For instance, if Joe decided that he wanted to limit his risk to $1,000, he could set a stop order to close his position at whatever the price level would be for that $1,000 loss.

He would still keep any interest payments he received while holding onto the position.

What is Carry Trade?

One of the most popular investments in the financial markets today is the carry trade. This involves selling or borrowing an asset with a low-interest rate, with the aim of using the proceeds to fund the purchase of another asset with a higher interest rate. By paying a low interest rate on one asset and collecting the higher interest earned by the other asset, you profit from the interest rate difference.

How Currency Carry Trading Works

When it comes to currency trading, a carry trade is one where a trader borrows one currency (for instance the USD), using it to buy another currency (such as the JPY). While the trader pays a low interest rate on the borrowed/sold currency, they simultaneously collect higher interest rates on the currency that they bought. The interest rate differential between the two currencies is the profit. Carry trading gives currency traders an alternative to “buying low and selling high” – a tough thing to do on a day to day basis. Most forex carry trading involves currency pairs such as the NZD/JPY and AUD/JPY due to the high-interest rate spreads involved.

Pros and Cons of Currency Carry Trading

Placing trades to take advantage of carry interest gives you an advantage since, in addition to trading gains, you also receive interest earnings. Carry trading also lets you make use of leverage to trade assets you would not otherwise be able to afford. The daily interest paid on the carry trade is based on the leveraged amount, which can make for huge profits from a relatively modest outlay. Still, carry trading carries significant risk, specifically due to the uncertainty in exchange rates. The high levels of leverage utilised in carry trades mean that even small movements in exchange rates could result in large losses if a trader fails to hedge their position appropriately. Due to these reasons, carry trading is only a good option for traders with a high-risk appetite. In any case, it should never be the main driver of your trades, but an additional aspect that gives you an advantage over the financial markets.

Risk Management in Carry Trading

There is no doubt that carry trading, while potentially lucrative, carries a fair amount of risk. This is because the best currencies for this type of trading tend to be some of the most volatile. Negative market sentiment among traders in the currency market can have a rapid and heavy effect on “carry pair” currencies. Without adequate risk management, a trader’s account can be wiped out by an unexpected, brutal turn. The best time to enter carry trades is when fundamentals and market sentiment support them. They are best entered at times of positive market sentiment when investors are in a buying mood.

Carry trade main FAQs

• Why might a carry trade end badly?The problem with the carry trade is the uncertainty that comes with exchange rates. The rapidly changing forex exchange rates make it important for a trader to consider more than just the interest rate on a carry trade. The directional trend of the pair should also be taken into consideration since a move in the wrong direction can easily wipe out any profits made from the interest differential in the carry trade. That means a large loss can be realized even as the trader makes money on the interest rate difference.
• Is the carry trade profitable?There’s a theory that any interest rate differential should be offset by a corresponding change in the value of the currencies involved. So, in an efficient market the currency with the higher yield should depreciate to offset that higher yield. However historical data shows that this is not the case. In most carry trade situations, the higher yielding currency also appreciates versus the lower yielding currency, letting traders not only collect the yield differential, but also collect a return on the appreciation of the higher yielding currency.
• What is the Yen carry trade?The Yen carry trade, in which traders bought the U.S. dollar for its high yield while selling the almost yield-less Yen, was last in fashion in the earlier part of the 21st century, basically from 2004 to 2008. After the 2008 financial crisis U.S. interest rates dropped enough that the so-called Yen carry trade was no longer profitable. However, the Yen remains at zero interest rates and it is possible to participate in a Yen carry trade by buying the Australian dollar or New Zealand dollar while selling Yen. So in that respect the Yen carry trade remains alive.

Conclusion

Carry trading is a strategy that has the potential to be highly profitable over the long term if correctly managed. The steady stream of income it can provide can cushion you from the negative effects of exchange rate movements. The education center contains a host of articles that can help you understand the various trading strategies available for the money markets, including carry trades. We also show you different ways to hedge your trades in order to mitigate and manage exchange rate risk. You can also put your carry trading skills to the test on our free demo account before you commit to investing real money. It is the best and most painless way to get your feet wet trading forex online in the international market.

A carry trade is when you borrow one financial instrument (like USD currency) and use that to buy another financial instrument (like JPY currency).

While you are paying the low interest rate on the financial instrument you borrowed/sold, you are collecting higher interest on the financial instrument you purchased. Your profit is the money you collect from the interest rate differential.

This is another way to make money in the forex market without having to buy low and sell high, which can be pretty tough to do day after day.

Carry trades work best when investors feel like taking on risk. Current economic conditions need not be good, but the outlook does need to be positive. If a country’s economic prospects aren’t looking too good, then nobody will be prepared to take on the risk.

To put it simply, carry trades work best when investors have low risk aversion.

Carry trades do not work well when risk aversion is HIGH.

When risk aversion is high, investors are less likely to buy higher-yielding currencies or likely to reduce their positions in higher-yielding currencies.

When economic conditions are uncertain, investors tend to put their investments in safe haven currencies, which tend to offer low interest rates like the U.S. dollar and the Japanese yen.

It’s pretty simple to find a suitable pair to do a carry trade. Look for two things:

1. Find a high interest differential.
2. Find a pair that has been stable or in an uptrend in favor of the higher-yielding currency. This gives you the ability to stay in the trade AS LONG AS POSSIBLE and profit off the interest rate differential.

Always remember that economic and political factors are changing the world daily. Interest rates and interest rate differentials between currencies may change as well, bringing popular carry trades (such as the yen carry trade) out of favor with investors.

So when doing a carry trade, you should still limit your losses like a regular directional trade.

When properly applied, the carry trade can add significant income to your account, along with your directional trading strategies.