Carry Trade on Forex

October 3


Posted by: Lorraine Longman,
 October 3, 2020

Minute Read

How Carry Trade Works

Many traders adhere to technical analysis and follow it religiously. This is a one-sided approach to Forex. Fundamentals are also worth considering, as they can tell you a lot about the market situation. 

Fundamental trading is based on a special set of strategies. It looks at factors like GDP, trade deficit, employment, and interest rate – general indicators of economic health. Carry trading is one possible approach. Here is how it works.

Fundamental vs. Technical 

Do not focus on indicators alone, even if someone told you they are the best. Explore different avenues of research. Do not discard fundamentals completely. Sooner or later, they may come in handy. So, what is the carry trade all about?

How to Define Carry Trading

This strategy is one of the least complicated. It is built around interest rates set by central banks of different countries. These show a trader how healthy an economy is, and whether its currency is likely to appreciate in the near future. The higher the interest rate – the more robust the system. It is a telling indicator. 

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First, you need to know what defines it. Weak economies have low rates, as the central bank is focused on stimulating credit growth. Local businesses can borrow money cheaply. As a result, a lot of it is injected into the economy. Eventually, the national currency loses value. 

Strong economies, on the other hand, have high GDP growth. Their inflation rises, causing interest rates to be increased. Such actions by the central bank are designed to push the local currency up. Carry traders have to understand the mechanics of interest rates around the world. 

Basic Definition

So, what is carry trade? As different countries have different interest rates, investors can capitalize on those distinctions. This method is practiced by banks and other large institutions. Retail traders may also use it to gain profit. 

Such trading is based on the premise that you can make money by buying a currency with a high-interest rate and shorting (or borrowing) a currency with low interest. Here is a basic example. 

Carry trade

An investor borrows ¥1,000 from a bank in Japan at 0% interest. They convert this amount to US dollars to buy a US bond which yields 4.5% interest. Provided that the USD/JPY rate remains stable, the investor will make a 4.5% annual profit. Now, let’s turn to retail Forex. 

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Suppose you wanted to capitalize on the interest rate gap between the Japanese yen and the Australian dollar. The first currency may be bought cheaply, and the second one brings a good return. In this case, the JPY is the funding currency, and the AUD is the investment currency (aka ‘carry currency’). In theory, if the same action is taken by other market participants, the demand for the Australian currency will go up, and the AUD/JPY pair will appreciate. 

To practice the strategy, retail traders need to learn about swaps that are accessible via trading terminals. A swap occurs when you move your open positions from one trading day to another. Leaving positions open overnight could entail special overnight costs, but it may also bring gain depending on the interest rates involved. 

Consider the following scenario for AUD/JPY. Currently, the Australian dollar has a better interest rate than the Japanese yen. A trader who buys the pair and holds it earns the difference in interest between the base and the quote currency. This gap constitutes the ‘swap.’ On the other hand, if you sold the pair, you would be paying the swap instead of earning it. 

Which Pair Is The Best for the Carry Trade?

Finding a profitable pair is easy. For example, users of the MetaTrader terminal can compare interest rates via the Market Watch feature. To check a specific pair, click on it. A window containing ‘Specification’ will pop up. Clicking on it summons another ‘Contract Specification’ window, where you can see the necessary details.

You will see a list of parameters including values for ‘swap long’ and ‘swap short.’ As swaps can be both positive or negative, you need to make sure you can profit on holding the pair. For instance, the positive swap for AUD/JPY can be 0.9. However, do not trade just yet – you need confirmation. 

The pair we are discussing saw a gradual rise over an 8-year period – from 2000 to 2008. Instruments that see such strong trends are generally safe to invest in. Compare historical data to the present-day situation. Is there a new uptrend that has already started? How strong does it look? Go ahead with the long position if you find sufficient confluence. 

Important Aspects of the Strategy

In general, carry trade is a simple strategy to pursue. If you are focused on long-term profit, this is a suitable approach. However, there are a few caveats here. Discover four important subtleties of the carry trade strategy.

Only Appropriate For Long-term Trading 

If you can only handle short timeframes, it will be challenging to follow the strategy. Momentary ups and downs may cause you to abandon it. What sets investors apart from short-term speculators is their ability to see the big picture. Any up or down you see may be merely a correction. Corrections may last for several days, so rookies misconstrue them as trend reversals.

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This Is Not Active Trading

In fact, it is the opposite. Carry trade positions may remain open for months. Those who are used to more hectic styles, such as scalping, will need to adopt an entirely different philosophy. Here, confidence, patience, and composure will bring success.

Do Not Expect Huge Profit

Of course, it depends on the volume you trade. Carry traders are generally viewed as low-risk moves. And as any trader should know, where the risk is low, so is the profit. Do not anticipate spectacular returns. The only way to win big is by using a large deposit. This may be achieved through leverage, which will also increase the risk. 

Keep Track of Fundamentals

Do not perceive carry trade Forex as a passive strategy. The long timeframe does not mean you can sit back and wait for the profit to accumulate. Your pair may still change direction. 

Holders of such positions should monitor factors affecting the corresponding interest rates. For instance, the AUD/JPY pair saw growth for many years which came to an abrupt end when the crisis unfolded. The economic bust of 2008 prompted investors to turn to the Japanese yen as a safe haven. See if the interest rates are likely to change. Even expectations of such changes may sway the currency rates. 

The Bottom Line

At its core, carry trading is unsophisticated. It is a strategy based on the difference between interest rates for two currencies. Modern trading tools calculate the swap for you, so you can easily find the best bet. Currency pairs are not the only option. The same strategy may be applied to the gold carry trade.

In comparison with more advanced methods, little financial knowledge is required. What you need is patience, as your positions will last for months. Look out for likely changes in the interest rates and take action when the reversal is impending.

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