What is a carry trade?
The Forex carry trade is a forex strategy which involves borrowing or selling a financial product with a low interest rate, and using the revenues to buy a financial product with high interest rates. Even though you have to pay interest on the product you borrowed or sold, you receive interest on the product with the higher interest rate.
In stable economic times the Carry Trade is very popular in the forex market. This has everything to do with the high leverage and the daily interest payments (so-called rollover rates, more on that below), which are common in online forex trading.
Why especially in stable economic times? Because this Forex strategy is doing particularly well when there’s not a lot of action and volatility on the currency market.
Not all forex brokers work with rollover rates. A good broker which does and, therefore, is ideally suited for carrying out a Carry Trade is Markets.com
The Forex Carry Trade basically consists of borrowing or selling a currency with low interest rates and then to invest the revenues in currency with high interest rates. You sell the currency with low interest rates (you pay interest over that amount) and you buy the currency with high interest rates (you receive interest over that amount). The difference between the high and low interest rate is called the “positive carry”.
All currencies in the forex market are traded in pairs. Major currency pairs are EUR / USD, GBP / USD and USD / JPY. When you want to speculate on a rise of the euro against the US dollar you buy the EUR / USD.
In really, this means that if you open a mini position of $ 10.000 (1 pip = $ 1), you simultaneously buy 10.000 in Euros and sell 10.000 in US Dollars. If you’re right and indeed the euro rises against the dollar, you get so when you exit the position more dollars back for Euros.
The interesting thing about the Carry Trade on the Forex market is that every day interest is paid on the positions you have left open at the end of the day. The forex broker closes and reopens the position and then credits / debits the difference in the overnight interest rate between the two currencies. (The Euro and the Dollar in our example above). These are the costs of “carrying” the position to the next day. This is also called “rolling over”. The overnight interest rate is also called the rollover rate.
To be clear: if you leave a position open where you sell a currency with high interest rates and buy a currency with a low interest rate, you will have to pay interest. But vice versa, you will receive interest.
Now because the currency market works with leverage, you can ultimately receive very high interest incomes on the amount you actually have invest… (Now wait until you get the picture. Take your time, think about it)
Carry Trade example
Let’s assume a leverage of 100: 1. Many brokers offer 200: 1, and even 400: 1, but be aware that higher leverage can also mean higher risk.
A popular Forex Carry Trade is the Japanese Yen. The Japanese Central Bank keeps interest rates at very low rates since the mid nineties to stimulate exports. Currency traders who currently use the Carry Trade Strategy sell the yen – interest rate 0.10% – and buy the Australian Dollar -interest rate 3.75%. The difference of 3.65% is the so-called positive carry.
Suppose you want to put $ 1,000 in the Carry Trade using a leverage of 100: 1. That means that with your $ 1000 you can “buy” a total of $ 1,000 x 100 = $ 100,000.
Now suppose you hold this position for one year. You don’t buy this position for speculation, you want to make a profit.
There are now three things that can happen:
1. The position loses value. The Yen rises and rises, and after a while it breaks through your 100 pips limit, which is actually you stop loss. The position will be closed automatically and you can say sayonara to your $ 1,000 (possibly followed by a ritual hari kiri)
2 For the entire year the AUD / JPY moves relatively little. It goes up somewhat, it goes down a bit, , but at the end of the year it is more or less where it started. The position in itself didn’t give you any profit, but your $ 1,000 yielded 3.65% INTEREST on $ 100,000, or 365% interest on the $ 1,000 that you have actually invested. That would be a profit of $ 3,650 on an investment of $1,000. Not bad!
3 The position is gaining value. The Japanese Central Bank has again been jumping on the yen to get it into the ground as far as possible. Now you will have made a profit on your position as well, on top of the 365% interest. Even better!
And this is with a leverage of “only” 100: 1, while in the forex market it is not unusual to work with 200: 1 or more.
How to Spot a Good Carry Trade?
Two things are important:
1. Look for a currency pair with a big difference in interest rates.
2. Look for a currency pair with a clear trend in the direction you need it for your Carry Trade
See below the weekly chart of the AUD / JPY, for example, where the interest rate difference is 3.65% in favour of the Australian Dollar. Since early 2009, there is a clear uptrend in the Australian dollar, perfect for a positive Carry Trade with the Australian dollar as the purchased currency.
Carry Trading summarised
The Carry Trade can be very lucrative in the online forex trading. In a stable economic market, in which the relationships are relatively clear and a good, long-term trend can be spotted, the Carry Trade can generate high returns without much efforts or extreme risks.
Of course, this forex strategy has its risks, like all strategies. If you put all your capital in one single Carry Trade and the trade goes the wrong way you can lose everything. Never do that, it is not a government bond (by the way, these days you shouldn’t put everything in government bonds either)
Look for the difference in interest rates – don’t go for a 1% or 2% difference, that’s not worth it – look for the trend in the right direction, and invest a small portion of your capital in the trade. This should be a larger portion than you normally put into a speculative day trade of course. You are trading for the long-term, so you should give some space to the position.
I hope you have been given enough information to answer the question “What is a carry trade?”