What is the Carry Trade Strategy?
Carry Trade Strategy is a forex trading strategy that involves borrowing from a currency with a low-interest rate to buy a currency with a high-interest rate.
It is actually one of the most common forex trading strategies which have been in use for decades and still finds applicability in forex trading today.
The difference in interest rates between the two currencies being traded can be so significant if highly leveraged and this gives meaning as to why the strategy has been so popular.
The only concern with Carry trading is that it may expose your capital to the risk of loss.
This is because carry trades are usually highly leveraged and as we all know, leverage is a double-edged sword.
If the trade goes against you, the losses will be so significant that small accounts may even be in danger of depletion.
You realize then that carry trading strategy will require huge amounts of capital so that high leverages will not quickly deplete your account.
The Principle behind the Carry Trade Strategy.
Borrowing to Buy:-
We already established that Carry Trading involves borrowing from a low-interest rate currency and buying a high-interest-rate currency. What if we clarify that with an example?
Look at these interest rates of different currencies:-
- Australian Dollar (AUD) – 3.50%
- New Zealand Dollar (NZD) – 2.50%
- European Euro (EUR) – 1.50%
- Canadian Dollar (CAD) – 0.50%
- Great British Pound (GBP) – 0.50%
- S Dollar (USD) – 0.20%
- Swiss Franc (CHF) – 0.20%
- Japanese Yen (JPY) – 0.15%
You can see that each currency has a different interest rate from the other and it is these interest rates that determine which two currencies you combine to trade.
By the way, these interest rates are determined by the Central banks of the respective economies of the specific currencies and they’ll keep on changing. Therefore you need to keep checking to know how they are.
Assuming we use the table above, the AUD and the NZD are high-interest-rate currencies from the displayed data. On the other hand, the JPY is a low-interest rate currency.
Meaning, you can combine AUD and JPY or NZD and JPY and enter a Buy position for the respective currency pairs (AUD/JPY or NZD/JPY).
That way, you will have borrowed from the low-interest rate currency (JPY) to buy the high-interest rate currency (AUD or NZD).
Note, the two chosen currencies have the largest interest rate difference or spread from which you are bound to profit in terms of daily interests.
Earning or Paying Interests Daily.
Here comes an interesting bit of Carry Trading – Earning or paying interests Daily.
One thing that is encouraging with Carry Trading is that there is interest earned if you go long or are in a Buy position of such a currency pair as AUD/JPY based on what we explained.
On the flip side, if you are short or in a Sell position of the same pair, unfortunately, you will need to pay the interest from your capital.
This interest may not apply to day traders who hold positions only to close them before the day ends.
Trades will need to be in place for several days because the interest is accrued daily. Remember Saturdays and Sundays find currency markets closed? Then the interest is accrued daily and tripled on Wednesdays to cover weekends.
If not for anything else, the interest alone could keep you waiting longer.
Remember what you are being paid for here? You are being paid for waiting until your anticipated rise in the price of the currency pair happens and for waiting until your take profit order is activated.
Now, here is the condition for the earning interest – the price of the currency pair either remains unchanged or rises, as you had anticipated.
If the price falls, you will have to forget about earning this interest and instead be charged at the same rate.
So what does that mean?
It means you will pay interest daily and a triple of it on Wednesdays just as those who are long are being paid.
Come to think of it, this is a very risky endeavor, or is it?
That’s if to go by the high leverages and interest rates charged for this strategy.
If it interests you, let’s discuss the formula used to calculate these interests:
- Daily Interest = (Interest rate of long currency minus Interest rate of the short currency) divided by 365 Days then all multiplied by the Notional Value.
Let us take the example of AUD/JPY from our values above. 1 lot of AUD/JPY has a notional value of $100,000 and we assume you Buy 1 lot.
Daily Interest = (0.0350 – 0.0015) divided by 365 then all multiplied by $100,000 which will make $9.
That means that if you had gone long (Buy position) on AUD/JPY, you earn $9 daily with exception of weekends which are compensated on Wednesdays when you earn$27 as interest, as long as the price of the currency pair remains unchanged or rises as you anticipated.
Now, if the price falls instead of rising or remaining the same, you will be paying $9 from your capital daily except weekends which you will compensate for on Wednesdays by paying $27.
Remember we said that the interest rates keep on changing, so $9 is based on the interest rates at that particular time.
The Daily interest will be calculated based on the interest rates of the various currencies on that particular day.
That means that it may vary from $9 to more or less each day depending on the interest rates of the day.
Wrapping up on the Carry Trade Strategy.
From the above insights, you can see that you earn from interests even if the price of the chosen currency pair does not move, with only more earnings coming in if the price moves in your favor.
However, it is devastating where the price moves against you because, in addition to grave losses, you will be required to pay interests daily.
What this calls for is adequate search for interest rates and careful scrutiny in order to enter a trade that is most likely to either have a price move in your favor or have the price remain unchanged.
Where you are looking for prices remaining unchanged, low volatility conditions are the best.
The best way to carry trade is actually to have a basket of at least 3 high-interest rate currencies and 3 low-interest-rate currencies to combine in pairs.
So even if one currency pair fails, you can control your losses with the other two having a possibility of succeeding.
Carry trading Strategy, as you can see, can be one of the best forex trading strategies with proper research of currency interest rates and proper currency pairing.
However, it may not be the best beginner forex trading strategy given that trades are left to run for days or months and patience is a virtue most beginners can only imagine in trading.