What is Carry Trade?
Did you know that there is a trading system where you can make money if the price stays exactly in one direction for a long time? That’s right and it’s one of the most popular ways to make money for many of the most
biggest and best money managers in the financial world. It is called the Carry Trade.
The carry trade is about borrowing or selling a financial instrument with a low interest rate, and then using it to buy a financial instrument with a higher interest rate. While you are paying the low interest rate on the financial instrument that you borrowed or bought, you are accumulating high interest on the financial instrument that you have purchased. Therefore your benefit is the money you accumulate from the interest rate differential. For example:
Let’s say you go to a bank and borrow $10,000. Your loan interest is 1% of the $10,000 each year. With that borrowed money, you buy bonds with the $10,000 that pays 5% a year. What is your benefit? It’s 4% a year! The difference between interest rates!
How Does Forex Carry Trade Work?
In the foreign exchange market, currencies are traded in pairs (for example, if you buy the USD/CHF pair, you are buying US dollars and selling Swiss francs at the same time). Like the previous example, you pay interest on the currency position you sell, and earn interest on the currency position you buy.
What makes the carry trade special in the forex market is that interest payments occur every day based on your position. Technically, all positions are closed at the end of the day in the forex market. You don’t see this happening if you hold a position the next day.
Brokers close and reopen your position, and then debit or credit you for the interest rate difference between the two currencies. This is the cost of “holding” (also known as “rolling over”) a position until the next day.
The amount of leverage available from forex brokers has made the carry trade quite popular in the forex market. Forex trading is completely margin based, which means that you only have to put up a minimum required amount of the position and your broker will put up the rest. Brokers generally ask for only 1% or 2% of the position.
Carry Trade Criteria
It is quite simple to find a pair to carry trade. You should look for two things:
- Find a pair with a high interest rate spread.
- Finding a pair that has been in an uptrend, where the currency you have
been going long has been gaining value against the currency you are
in short position.
Let’s take a real example of the carry trade in action:
This is a weekly chart of the GBP/JPY. Until recently, the Bank of Japan has maintained a zero interest rate policy. With the Bank of England offering some of the highest interest rates among the major currencies, many traders have flocked to this pair (one of the factors in creating a slight uptrend in the pair). In late 2000 to mid 2006, this pair moved at a price of 150.00 to 223.00, that’s 7300 pips. If you combine that with the interest differential payments of the two currencies, this pair has been a good long-term game for many investors and traders to weather the volatility of the forex market’s bullish and bearish moves.
Of course, economic and political factors that are changing the world on a daily basis. Interest rates and interest rate differentials between currencies can change, and it also makes carry trades (such as yen carry trades) quite popular with investors.
Carry Trade Summary
As you can see there are other ways to make money in the forex market without having to buy low and sell high, which can be difficult to do day in and day out.
If you pick the pair (one with a high interest rate spread) at the right time, then you will win just by accumulating money from the market. When applied properly, the carry trade can add significant income to your account, along with your directional trading strategies.