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The Forex Carry Trade Explained
10/20/2011 6:00 am EST
This video and transcript reviews the important factors for traders to consider when planning and executing a carry trade, which delivers income and capital gains based on long-term rate differentials between two currencies.
In this video, we’re going to talk about the carry trade. Simply put, a carry trade is a long-term position where a trader attempts to earn interest as well as capital gains on their positions. To set the stage, we need to begin by establishing and understanding rollover, as this is a major component of any carry trade. This is the interest component.
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Rollover is the interest earned or paid for holding a position overnight or into the next trading day. Each currency has an interest rate associated with it, and because FX is traded in pairs, every trade involves not only two different currencies, but there are two different interest rates.
So let’s talk about why certain traders are in rollover and why other trades have to pay rollover interest. If you buy the Euro/USD, you’re essentially buying euros and selling US dollars. If you sell the Euro/USD, you’re selling the euro and buying US dollars. If the interest rate on the currency you buy is higher than the interest rate on the currency you sold, then you will earn rollover interest. So in this case, we’re essentially borrowing or selling currency at a low interest rate in order to invest or buy into a currency that yields a higher interest rate.
If the interest rate on the currency you bought is lower than the interest rate in the currency you sold, then you’ll have to pay rollover. Again, in this case, you’d be borrowing or selling currency at a relatively high interest rate to invest or buy into a currency that yields a lower interest rate.
Now with all this said, how do you know how much interest you’ll have to pay or earn when you do hold positions long term?
Fortunately, you don’t have to calculate rollover rates yourself as the FX trading station 2 automatically calculates and reports all rollover for you and the rollover rates can be found from the simple dealing rates window of the platform in the Roll S and the Roll B columns.
We can see here that by buying the Australian dollar/US dollar currency pair, a trader would earn $3.67 in interest everyday at the 5 p.m. Eastern close for each 10K lot that they traded.
Understanding the role that interest rates play in the FX market is a crucial task in becoming a successful carry trader. There’s a lot to understand regarding interest rates and interest rate environments, and we’ll cover the basics now. However, for a more detailed understanding, make sure to watch our part 2 video on the carry trade.
A country offering high interest rates will typically attract more capital as investors seek to capitalize higher returns. As interest rates rise, investments will follow, which can in turn increase the value of the currency. In most cases, a higher interest rate will usually lead to higher currency value, while a lower interest rate will usually lead to lower currency value.
A carry trader’s focus then becomes the expectation on the direction of the country’s interest rate to ensure their high rate of return. Now this is a little different than just checking to see the two interest rates and assuming that the market will go with the currency with the higher interest rate.
Traders prefer to own the currency with the higher interest rate that continues to rise and prefer to sell the currency with the lower interest rate that continues to fall. So it’s also the expectation of future interest rates that traders use in their trading approach.
So carry traders anticipate future interest-rate moves in their decision on what pair to buy or sell as much as they depend on the current interest rate environment. But it doesn’t make much sense to buy a pair that is in a downtrend just to earn interest. Making $3.67 in interest a day only to lose $100 a day in market movement will not lead to consistent profits.
So it’s also important to note the direction of the daily trend and to only trade in that same direction. When you’re trading with the trend and at the same time earning interest, it can be very profitable. The daily trend of the Australian dollar/US dollar is up, and by buying this pair, you can also earn $3.67 a day in rollover interest. Now this is a situation that carry traders look for for trading opportunities.
But let’s go through the process of identifying the best candidates for a carry trade to see if there are any better opportunities.
The first thing we want to note is the pairs that offer the highest rollover interest credits. We start off by checking the simple dealing rates window on the trading platform for this input. We only want to note the positive numbers, as that represents what we can earn. Those numbers that are negative are what we would have to pay on a daily basis for an open position.
Under the Row S column, we can see where the Euro/Australian dollar shows 6.39, while the GBP/Australian dollar shows 6.92. This is what we could earn for each 10K lot sold since the S in Row S means sell. This account is funded in US dollars, so we can earn $6.92 a day for every 10K lot of the Pound/Australian dollar that we sold.
In the Row B column, we can see what the debit or credit would be for each 10K lot that was bought. We can see that we can earn $4.27 a day for each 10K lot of the Australian dollar/Japanese yen that we bought or $4.00 a day for each 10K lot of the Australian dollar/Canadian dollar that we would buy. These are the four highest totals, which is something we recommend doing as the first step for looking for a carry trade.
The next step is to identify the strong trending moves that support the carry trade. Let’s start with the Pound/Australian dollar currency pair. Remember that we earn $6.92 a day for every 10K lot that we sell, so we want to make sure that the trend is down to increase our chance of success on this trade. Remember, the idea is to earn interest and to be in a profitable trade at the same time.
Here’s a daily chart of the Pound/Australian dollar, and you can clearly see that the trend is down. The daily chart with one year of trading shows a strong downtrend noted by a series of lower highs and lower lows. This is the situation we look for in a carry trade, that there is strong possibility of earning interest in addition to being a profitable sell position.
Let’s take a look at another potential trade. This is the daily chart of the Euro/Australian dollar with one year of trading plotted. This is another good example of a downtrend with a series of lower highs and lower lows. The trend is not as strong as we saw on the Pound/Australian dollar, but it’s a worthy carry trade opportunity just the same. In addition to potentially profiting with an open sell position, we can also earn $6.39 a day in interest for every 10K lot that we hold short.
Now let’s look at one more chart to compare the differences. This is a daily chart of the Australian dollar/Japanese yen with one year of trading. We can see a nice uptrend, which does support our carry trade. This pair generates $4.27 a day in interest for every 10K lot. But the trend supports the trade since we can potentially profit from the move up at the same time.
These are all examples of carry trades that we want to be looking for. Hopefully, you can now see why the carry trade can be so popular, but before closing this video, let’s recap what we’ve talked about by going over what to watch out for when setting up a carry trade.
- Make sure you first note the largest credits in the simple dealing rates window of the FX trading station, then start with the highest amount you can earn and look for strong trends in that same direction.
- When you enter into the trade, always trade with a protective stop in the market for those times when the market reverses and moves against your position.
- Make sure you use a solid method for identifying your entry and exits. Don’t just buy or sell based on rollover credits alone.
- Try to stay in the trade as long as possible. Time is your friend in a carry trade since we’re looking for that interest rate component.
- Be aware of a change in direction of the interest rate environment. Even though a pair may still offer a nice interest credit, the trend can change at any time based on future interest rate expectations.
- Finally, once you’re in a trade, manage the trade without regard to interest that’s being earned. A move against your position can quickly offset any interest you’ve earned.
By the Staff at DailyFX.com
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