Due to the interest rate hikes practiced by central banks in recent months, the Carry Trade has once again become a profitable trading method.
Reading Time: 7 minutes Financial activity: Trading Knowledge level: Beginner
Summary
What is Carry Trading?
How does Carry Trading work?
How Carry Trade is calculated?
Strengths and Weaknesses of Carry Trading
A real market example
Conclusion
What is Carry Trading?
Carry Trading is a trading method
that involves borrowing money in one currency with a low-interest rate and
investing it in another currency with a higher interest rate.
The goal of Carry Trade is to
profit from the difference in interest rates, which is called “the carry”.
For example, an investor might
borrow the Japanese yen (JPY) at a low-interest rate and invest it in US
dollars (USD), which have a higher interest rate. The investor would then earn
the difference in interest rates, which would be paid out in USD.
This is the link if you want
to be updated on the current value of the interest rates of the main central
banks: Central banks rates.
How does Carry Trading work?
Using the same example as
above, I can Carry Trade by simply buying the USD/JPY pair and holding the
position for as long as possible.
So, Carry Trading is a
relatively simple strategy, but it can be risky. The main risk is that the
currency you are borrowing will appreciate against the currency you are
investing in. This would cause the value of your investment to decline, and you
could lose money.
Another risk of carry trading
is that the interest rates in the two currencies could change. If the interest
rate in the currency you are borrowing goes up, or the interest rate in the
currency you are investing in goes down, your profits could be reduced (or even
eliminated).
How Carry Trade is calculated?
The daily interest is calculated in the following way:
Suppose the currency you are long on has an interest rate of 5.25% and the currency you are short on has an interest rate of -0.10% (look at USD/JPY). Also, suppose that you have bought one lot (100000 $, notional value):
[0.0525 - (-0.001)] / 365 x 100000 = 14.66 $ per day
The interest is paid every day, with triple rollover given on Wednesday to account for Saturday and Sunday rolls.
Notice: the amount will not be exactly $14.66 because banks will use an overnight interest rate that will fluctuate on a daily basis. Based on my experience, I can say that each broker applies these interests differently from the others, so you need to conduct specific research about it.
Strengths and Weaknesses of Carry Trading
The main strength of Carry
Trading is that it can be a very profitable strategy, using very low effort! If
you can identify currencies with high-interest rates and low-interest rates,
you can potentially earn a significant amount of money from carry trading.
As mentioned above, there is a
risk that the currency you are borrowing will appreciate against the currency
you are investing in. This could cause you to lose money.
Another strength of carry
trading is that it is a relatively simple strategy to understand and implement.
Even beginner traders can learn how to carry trade, and it does not require a lot
of capital to get started.
Tip to reduce risk (important):
try to combine Carry Trading with the indications coming from the Commitments
of Traders Report (COT), the most important market sentiment indicator.
This is my old post about COT: Beginners Guide to Commitments of Traders Report (COT).
A real market example
I want to give a real example of applying this strategy: NZD/CHF (New Zealand Dollar/Swiss Franc).
Currently, the value of this currency pair has fallen to an all-time low.
The interest rate charged by the Reserve Bank of New Zealand (RBNZ) is 5.50%.
The interest rate charged by the Bank of Japan (BOJ) is -0.10%.
Considering all of the above, I think it's a good idea to buy NZD/CHF and hold this position for the coming weeks/months.
Conclusion
Carry trading is a simple and
potentially profitable trading strategy: a trader using this strategy attempts
to capture the difference between the rates of two currencies.
However, it is important to be
aware of the risks involved before you start Carry Trading. If you are not
comfortable with the risks, you should consider using a different trading
strategy.
Here are some additional tips for carry trading:
- Diversify your portfolio by investing in multiple currencies.
- Monitor the markets closely and be prepared to exit your trades if the risk-reward ratio becomes unfavorable (eventually, use a stop-loss order to protect your profits).
A sincere wish of good work to all!
Written by F. GRAMOLA (*).
(*) Member of S.I.A.T., the Italian Society of Technical Analysis (member society of I.F.T.A. – International Federation of Technical Analysts).
Warning
We merely cite our personal opinions for educational purposes only.
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Investing and trading are risky. Don't invest or trade money that you cannot afford to lose.
Initial photo by jun rong loo on Unsplash.
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