Educational

Carry Trading and Its Benefits

Carry trading is a forex trading strategy that involves borrowing or selling a financial product with a low interest rate. Then, the trader uses the revenues to buy a product with high interest rates. While you have to pay interest on the product you borrowed or sold, you receive interest on the product with the higher interest rate.

During stable economic times, carry trading becomes very popular. This has a lot to do with the high leverage and daily interest payments. These interest payments are also called rollover rates and they’re very common in online forex trading.

carry trading embedded on a man in suit

Carry trading is popular during economic robustness since the forex market does particularly well. There’s not a lot of actions and volatility in the currency market during such times.

SEE ALSO: Best Currency Pairs to Trade

How Does Forex Carry Trading Work?

Forex carry trading essentially consists of borrowing and selling a currency with low interest rates. Then, the trader will invest the revenues in currencies that have high interests.

Simply put, you sell the currency with low interest rates and buy the currency with higher rates. You call the difference between the low and high interest rate as the “positive carry.”

Traders trade currencies in the forex market in pairs. Among the major currency pairs are EUR/USD, GBP/USD, and USD/JPY. If you want to speculate on the strength of the euro against the dollar, you buy EUR/USD.

In practice, this means that if you open a mini-position of $10.000 (1 pip = $1), you buy 10.000 in euros at the same time. You will then sell 10.000 in US dollar. If your speculation is right and the euro rises against the dollar, you will exit the position with more dollars back.

An interesting thing about carry trading is that every day you get interests on the positions you have left open. Your broker closes and reopens the position and then credits/debits the difference in the overnight interest rates of the currencies.

[READ FURTHER: Finding the Best Portfolio Manager: Responsibilities and Qualities]

These are the costs of “carrying” the position to the next day. Traders and brokers also call this “rolling over.” The overnight interest rate is also the rollover rate.

And since the currency market works with leverage, you can actually achieve very high interest income.

An Example

To illustrate carry trading, let’s suppose you have a 100:1 leverage. Many brokers provide 200:1 and even 400:1. However, keep in mind that higher leverage may also mean higher risk.

One popular carry trading currency is the Japanese yen. The Japanese Central Bank keeps its interest rates very low to spur exports. As a carry trader, you will sell the Japanese then with the interest rate of 0.10 percent. Then you buy the Australian dollar with the interest rate of 3.75 percent. The difference 3.65 percent is what you call the positive carry.

Suppose that you want to put $1,000 in the carry trade with a leverage of 100:1. That means you can “buy” a total of $100,000 with your $1,000.

And now imagine that you hold this position for one year. You don’t buy this position for speculation and you want to make a profit. What will happen?

Possible Outcomes:

  1. The position loses value. The yen will rise and rise. After a while, it breaks through the 100 pips limit, which is also your stop loss. The position will close automatically and you may have to say goodbye to your $1,000.
  2. For the whole year, the AUD/JPY moves only a little. It goes up somehow and then it goes down a bit. But by the end of the year it’s more or less the same. The position in itself isn’t profitable. But your $1,000 already yielded 3.65 percent interest on $100,000, or 365 percent interest on the $1,000 that you have actually invested. That means you have a profit of $3,650 on your $1,000 investment.
  3. The position gains value. The Bank of Japan has been jumping on the yen to roll it as far as possible. Now, you will have made a profit on your position as well, on top of your 365 percent interest.

How do we spot a good carry trading opportunity?

In general, there are two things that you have to focus on.

First, you have to look for a currency pair with a big difference in interest rates.

Second, search for a clear trend in the direction you need for the carry trade.

Benefits

The benefits are quite obvious. By trading in the direction of the positive interest, you’d gather a premium payment every day. This would cushion your bottom line profit over and over again. And with the help of leverage, your actual return on capital is bigger.

On the flip side, sometimes luck is not on your side and the trade goes against you, plus you’re using leverage. The amount of rollover you collect may not be sufficient to make up for the profit decline.

The key to successful carry trade is not simply trading a currency with high interest rate and another with a lower rate. Instead, it’s more important to mind the direction of the spread. For an ideal carry trade, go long on a currency on its way of expanding. And then go short on a currency with a contracting interest rate.

You can generally predict that by checking what the currency’s respective central banks are saying. The central bank of the long currency should be looking to raise the rates. Meanwhile, the short currency’s central bank should be looking to lower interest rates.

Conclusion

Carry trading is a very lucrative strategy in the online market. in a strong economy, the carry trade strategy can whip out returns without much effort and extreme risks. Always look at the difference in the currencies’ interest rates. Look for a trend in the proper direction. Only invest a small part of your capital.

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