Carry Trade Strategies in Forex Trading
Updated 10 October 2020
If you’re new to the forex market, you’ll be getting to grips with the various strategies experienced traders use to execute profitable trades. One such strategy is the carry trade.
This article provides an overview of carry trading forex – what it means, how it works and how to implement your own carry trade strategy.
As a basic definition, to perform a carry trade is to borrow a financial instrument at a low interest rate and invest what you’ve borrowed into a second financial instrument with a high interest rate.
The intention is that, over time, you profit from the difference in the interest you pay and the interest you receive, referred to as the interest rate differential.
To understand this in practical terms:
- Assume you have borrowed £10,000 from a bank at an interest rate of 0.75%, the balance of which you agree to pay back over three years.
- You then take this money and invest in a three-year bond that yields 3.5% interest.
- Over the course of your agreements, you’ll pay 0.75% on your loan, but earn 3.5% on your investment, giving an interest rate differential and a profit on your £10,000 of 2.75%.
Carry trading forex works in much the same way. A trader will borrow a currency at a low interest rate, known as the funding currency, and use it to buy a second currency with a high interest rate, known as the carry or asset currency.
This is referred to as a positive carry trade, whereby the trader stands to profit from the interest rate differential.
If you were to trade a currency pair where the funding currency commanded a higher interest rate than the asset currency, you would be in a negative carry trade, paying more in interest than you stand to gain.
It is the fact that forex trading is conducted with currency pairs that makes it the ideal market to implement a carry trade strategy, since you are always selling one currency to buy another.
However, it is not as straightforward as it sounds, and it’s certainly not risk-free. When executed with knowledge and caution, a carry trade can result in a healthy profit margin.
Although the foreign exchange is a 24-hour market, when you open a position on a currency pair through a forex broker, that position is closed at the end of each day and reopened the following morning. Your account is then credited (or, if in a negative carry trade, debited) with the value of the overnight interest rate differential, known as the rollover.
So, as long as your position remains active and you’re in a positive carry trade, you’ll make profit on a daily basis.
This can be a huge advantage if the market also moves in your favour, since you’ll profit from the interest paid on your carry currency as well as from any appreciation in the value of the currency pair. Even if the market is stagnant and the exchange rate relevant to your trade does not move, you can still turn a profit thanks to the interest earned.
If you control a large amount in your trade, this can soon add up. Of course, if your currency pair depreciates, you stand to make a loss.
It is the amount that you control that is possibly the biggest advantage of carry trading forex as you have the option to make use of leverage.
What this means to you as a trader is that you can open a trade with a small deposit, known as a margin, and effectively borrow against it to command a much higher stake. The interest earned is based on the leveraged amount, not your initial deposit, so by trading on margin, you can achieve a much higher profit than you would earn on your capital alone.
There are two main risk factors involved in a carry trade, the first of which is adverse movement in the exchange rate of your currency pair.
As previously discussed, a positive carry trade on a currency pair that is appreciating is a great position to hold and can result in substantial profit. However, should the exchange rate turn against you and if you were to exit the trade at a loss, any gains from interest could be completely wiped out.
The second risk factor concerns the interest rates of the countries relating to the currencies you’re trading.
These are set by the respective country’s central bank and are, of course, subject to change. If a country has a low interest rate, it’s likely because it is looking to boost economic activity through consumer spending. As more money is spent, the economy grows, and interest rates are likely to rise proportionately, thus affecting the potential profit of your carry trade.
To be successful in carry trading forex, you need to choose your trades wisely and use historical data and market tools to your advantage. Below we cover some strategies.
1. Find Currencies With Large Interest Rate Differentials
The first port of call when carry trading forex is to identify available currency pairs with a significant difference in interest rates. Typically, these are found in cross-currency pairs; that is, any currency pair not inclusive of the U.S Dollar.
However, as always, it’s important to tread carefully here. At the time of writing, there are some countries with negative interest rates, namely Japan (-0.1%) and Switzerland (-0.75%), whilst others such as Turkey are as high as 10.75%. Though this differential may seem appealing, such high interest rates are often associated with economic instability, which can dramatically impact the value of a currency.
A successful carry trade is one that involves relatively stable currencies, so when considering interest rate differentials, you should also be looking at the historical trends of the currencies in question.
It’s also important to bear in mind that the interest rate differential according to rates set by the central banks isn’t necessarily what you’ll be offered by a broker. It may factor in its own charges, so you’ll need to look at the broker's own interest rate differential, commonly known as the forex swap.
2. Choose Stable Currencies or Look for Upward Trends
Opening a carry trade on a currency pair where either currency or both are volatile is a very risky move. Any profit gained in interest could be immediately wiped out by a sudden move in the market and you could well find yourself trading at a substantial loss.
Although risk often equals reward in forex trading, successful traders make strategic moves based on market knowledge to mitigate that risk.
So, when looking to open a carry trade, look for a historically stable currency pair or one in an upward trend that you expect to continue. This will protect you from adverse market moves and allow you to stay in your position for a beneficial amount of time.
Of course, there’s no guarantee here so you should also consider other risk management strategies, such as placing a stop loss on your trade.
3. Stay in as Long as Possible
The premise of carry trading forex is that you not only make money from trading one currency for another, but you also benefit from interest gained on the currency you’re buying.
Since this interest is added to your account daily, the longer you can keep your position open, the better.
Essentially, this means that a good carry trade strategy requires patience. It’s also why it’s so important to choose a currency pair that is likely to remain stable or move in your favour. When carry trading forex, you should commit to a long-term investment to reap the most substantial return.
4. Use Leverage to Increase Your Profits
As previously mentioned, by using leverage you can hold a much larger position, and subsequently earn more in interest than your actual capital alone would allow. This is why leverage is an integral part of any successful carry trade strategy.
Forex brokers typically offer retail traders leverage up to 1:30. By taking full advantage of this, a £333 deposit would see you earning interest on an investment of £10,000.
You do need to factor in the costs associated with borrowing funds. With a £333 margin, you essentially have a £9,667 loan, which your broker may well charge you interest on for the duration of the trade. Make sure you’re aware of all the costs involved to ensure that they do not severely impact your potential profit.
Of course, leverage is not without its downsides. If a positive carry trade was to be affected by a sudden change in interest rates and become a negative carry trade, you would then be paying interest on the £10,000.
With that in mind, leverage should be used wisely and in conjunction with a robust carry trade strategy that considers all aspects of potential risk.
Though popular with many experienced traders, carry trading forex is not a stand-alone strategy, and it is certainly not one from which you’ll see substantial short term gains. Instead, you should view a carry trade as a longer-term approach which complements other strategies in the management of your portfolio.
While there is money to be made from taking careful advantage of interest rate differentials, you should view this as an added bonus rather than the main focus of your overall approach.
Finally, as always, you should also ensure you have a solid risk management strategy in place, to protect you from any potential loss beyond what you’re willing to accept.
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