El Forex carry trading

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Carry Trading Forex Strategy

Carry trading with forex represents an interesting strategy for day traders. This article will provide a definition of carry trading, explain trading costs, momentum and timing – and highlight some of the pitfalls and issues that might impact performance.

  • Carry trading as it relates to forex involves going long a high-yield currency against a low-yield currency
  • Currency-related carry trading execution primarily relies on correctly timing interest rate cycles and having the backdrop of a low volatility, “risk-on” environment
  • Common pitfalls include indiscriminately chasing spread, failing to keep up on central bank monetary policies, using too much leverage, and lack of broader-level portfolio diversification

The Basics of Carry Trading

The entire basis of capitalist economic systems comes in the fundamental form of the borrower/lender relationship. It is the spread between borrowing and lending activity that forms the basis by which economic activity is transmitted and how financial markets are priced.

When you invest your money, you are fundamentally chasing a spread. If there was no future return on your money – that is, no spread – then there would be no point to trading or investing in the first place.

Definition

In financial markets parlance, this is typically referred to as “carry.” Carry can be loosely defined as the excess return over cash and can come in various forms:

  • credit – e.g., a bond or loan yielding X% over cash
  • duration – compensation for financial assets of longer maturities
  • volatility – markets tend to take high volatility or uncertainty into account by pricing financial assets lower
  • equity (stocks) – assets subordinate to other claims in a company’s financial structure and effectively of infinite duration
  • currency-related – borrowing in one currency and using it to buy another currency or financial assets of higher yield

Forex Carry Trading

Carry is one of the most foundational concepts in trading and investing and forex is no exception. Below I will provide examples of how the carry trade is structured with respect to trading currencies:

Forex carry trading broadly means borrowing in a cheap currency, such as the Japanese yen (JPY) or Swiss franc (CHF) and investing in either a higher-yielding currency – e.g., Mexican peso (MXN), Turkish lira (TRY) – or another financial asset.

What currencies are “high yield” and which are “low yield” is relative and dependent on interest rates. Central banks of certain countries or jurisdictions raise or lower short-term interest rates to ensure price stability and/or employment levels depending on their statutory mandate.

Among major currency pairs, AUD/JPY and AUD/CHF have been the more popular carry trade options with AUD being the “high yield” currency and JPY and CHF being “low yield” currencies.

If one were to be long the AUD/JPY, for example, interest would be earned daily. If one were short the pair, interest would be paid daily.

Forex broker OANDA provides a free tool to calculate financing charges on various currencies, where interest earned is a function of the currency pair traded, the number of units purchased, and the amount of time in which it’s held.

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Among the major seven currencies (eight if you include the New Zealand dollar (NZD)), the upper-bound overnight rates for each are as follows (also sometimes called benchmark or cash rates):

  • NZD – 1.75%
  • AUD – 1.50%
  • USD – 1.50%
  • CAD – 1.00%
  • GBP – 0.50%
  • EUR – 0.00%
  • JPY – minus-0.10%
  • CHF – minus-0.75%

Of course, the actual rates offered by any individual broker can materially differ from the spread obtained on trades as implied above. For example, while the above rate might suggest the annual carry from an AUD/CHF trade is 2.25% (1.50% – -0.75%), the actual spread offered by a broker such as Oanda is currently just 1.05%.

In today’s world of low interest rates, carry trades don’t provide the type of return among major currency pairs as they did previously. For that reason, many looking at carry trading strategies will have to go out over the risk curve and borrow in a cheap major currency in order to buy a higher-yielding emerging market (EM) currency in order to earn a yield beyond that of higher-duration US Treasury bonds (considered safe yield). EM currencies are inherently more volatile and subject to risk given they underlie jurisdictions that may be exposed to a less robust rule of law, poor institutions, political instability or corruption, low levels of investment and innovation, lack of private property laws, and/or undeveloped debt and capital markets.

On carry trades, if you are long the higher-yielding currency relative to the lower-yielding currency, interest is accumulated daily. Forex is a 24/5 market, so to compensate, interest is accrued three times the normal amount on Wednesdays.

If you were to buy a standard lot of AUD/CHF (100,000 units of the base currency), the daily interest accumulation would come to the 2.75% spread (assuming it was offered) divided by 365 (the number of days in a year) multiplied by the notional amount, or about USD$7.53 per day (if you bought a standard lot designated in US dollars).

For those short the AUD/CHF, interest is paid daily, just as someone shorting a stock would pay the dividend, if applicable.

Keys to Carry Trading

Follow the actions of central banks

Carry trades develop based on central banks adjusting interest rates, normally the front-end, “overnight” lending rate. The rest of the curve is generally set by the market (one exception is Japan, which also pegs its 10-year yield to keep its curve sloped upward to help banks lend profitably).

When one country tightens its monetary policy (i.e., raises interest rates and/or contracts its money supply) while another is easing (i.e., lowering interest rate and/or expands its money supply) or holding steady, this provides the opportunity not only for carry – assuming the country tightening its monetary policy has a higher-yielding currency to begin with – but for capital appreciation as well.

The idea of going long currencies before they tighten monetary policy and short those that are easing is, of course, a strategy that exists outside of the carry trade concept.

Identify the right environment

Carry trades became heavily unwound during the 2008 financial crisis as liquidity dried up and investors shunned risk-taking. Carry trades are ideal when markets are relatively placid and investors display an appetite for risk.

The Japanese yen and Swiss franc are often referred to as “safe havens” similar to gold (they generally have +20%-40% correlation with the precious metal). But this is only partially true. The yen and franc generally appreciate in value because the leveraged carry trades commonly funded by these currencies become unwound, not because of demand for these currencies themselves.

Carry trades are attractive to investors for much of the same reasons dividend stocks and coupon-paying bonds are. Namely, the market doesn’t have to move for you to make money. Thus, calm, low-volatility environments are generally prime for carry trade opportunities.

Pitfalls in Carry Trades

Carry trades have to be approached carefully and correlate with risk assets such as stocks and high-yield bonds more broadly.

Though AUD/CHF has fulfilled the definition of a carry trade over the past five years, it’s one that has lost money due to capital depreciation. The primary reason has been due to a down-cycle in commodities, as Australia, a resource-rich nation, is a net exporter of coal, natural gas, and uranium.

Global commodities have fallen in price since mid-2020, though have begun to rebound since their early-2020 bottom.

This has trickled into the AUD’s valuation as the Reserve Bank of Australia has cut interest rates to counteract the downswing in growth and inflation:

When central banks cut interest rates and yields decline, investors are likely to move their capital elsewhere to seek out more profitable trading opportunities. When this selling is exacerbated through the unwinding of leveraged positions, years’ worth of gains can be reversed quickly.

Indiscriminately going long a higher-yielding currency against a lower-yielding currency can land oneself in trouble. The more important focus is to determine how rates are likely to change in the future, which is a function of future growth and inflation prospects. Higher growth and inflation are associated with greater likelihood of rate hikes.

Even if you’re in a carry trade with a large spread to it – e.g., long TRY/JPY – if it’s believed that the central bank of Turkey is likely to ease relative to the Bank of Japan – both diminished carry (from a closing spread) and capital depreciation could impair the profitability of this trade.

On top of that, given currency traders often use leverage, even a relatively modest 10% dip in a currency pair combined with 10:1 leverage on a trade will wipe out one’s entire amount of capital committed to that trade. Properly managing risk is vital.

Conclusion

Like any strategy, carry trades must be employed prudently. While technicals, such as support and resistance levels, can be useful in finding entry points, carry trades should not be committed to without an understanding of where central banks are in their monetary regimes and what their next policy moves are likely to be.

Carry trades also tend to be long and directional. Interest rate policies mirror credit cycles. And business cycles typically last 5-10 years. Therefore, this is not a strategy that one would execute as part of a short-term trading orientation, as interest rate adjustments typically occur only once every few months (or years).

Limiting risk should also be accomplished via two main conduits: (1) using only small amounts of leverage (or possibly none at all) and (2) portfolio diversification.

For US-based traders, the Commodity Futures Trading Commission (CFTC) limits leverage available to retail forex traders to 50:1 on major currency pairs and 20:1 for non-major currency pairs.

However, most traders should not use anywhere near these amounts. At 50:1 leverage, a 2% move in the wrong direction will wipe out your entire capital base allocated to a particular trade. If you’re doing carry trading, an intrinsically long-term strategy, you need to allow at least 2% wiggle room for the trade to develop.

Most traders shouldn’t use above 5:1 leverage. Novices should start by using paper accounts and then by avoiding leverage once they begin trading live with real money and determine that they can prove to themselves that they can be profitable over a statistically meaningfully period of time (usually one or more years). Carry trading or trading in general is not a get-rich-quick scheme.

Regarding diversification, this isn’t strictly limited to being in various currency-related carry trades, but through diversification into other asset classes as well, including stocks, bonds, and real assets, such as gold or commodities.

What is the Carry Trade?

Did you know there is a trading strategy that can make money if price stayed exactly the same for long periods of time?

Well, there is and it’s one the most popular ways of making money by many of the biggest and baddest money manager mamajamas in the financial universe!

It’s called the “Carry Trade“.

“I’m tired of carrying this!”

What is a Carry Trade?

A carry trade involves borrowing or selling a financial instrument with a low interest rate, then using it to purchase a financial instrument with a higher interest rate.

So your profit is the money you collect from the interest rate differential.

Carry Trade Example:

Let’s say you go to a bank and borrow $10,000.

Their lending fee is 1% of the $10,000 every year.

With that borrowed money, you turn around and purchase a $10,000 bond that pays 5% a year.

What’s your profit?

You got it! It’s 4% a year! The difference between interest rates!

However, when you apply it to the spot forex market, with its higher leverage and daily interest payments, sitting back and watching your account grow daily can get pretty sexy.

To give you an idea, a 3% interest rate differential becomes 60% annual interest a year on an account that is 20 times leveraged!

Leveraged Carry Trade Example:

Let’s say you borrow $1,000,000 at an interest rate of 1%.

The bank won’t just lend a million bucks to anybody though. It requires cash collateral from you: $10,000.

You’ll get it back once you pay back the money.

Your loan is approved so fill up your backpack with cash.

Then you turn around, walk across the street to another bank and deposit the $1,000,000 in a savings account that pays 5% a year.

A year passes. What’s your profit?

You earned $50,000 in interest from the bond ($1,000,000 * .05).

You paid $10,000 in interest ($1,000,000 * .01).

So your net profit is $40,000.

With a measly $10,000, you earned $40,000!

That’s a 400% return!

We will also tackle risk aversion (WTH is that.

Don’t worry, like we said, we’ll be talking more about it later).

Best Carry Trade Strategy – The $14 Trillion Trade

Best Carry Trade Strategy – The $14 Trillion Trade

The number one trade in the Forex market is a $14 trillion dollar trade. This trade is captured with the best carry trade strategy. In most cases, it’s going to take a lot of time to become a profitable trader. However, if you choose the right currencies, the Forex Carry Trade strategy is the only strategy that will make you some profits on the first day.

Our team at TSG has put a lot of effort into providing traders with more information about the Forex currency market. If you don’t know how to protect earned profits in the currency market, it doesn’t matter how much money you make in the stock market or options market.

In the long term, you are not going to have any profits. Currencies are always being evaluated and they lose their fair value. We’re trying to give traders an opportunity to learn more about the currency market. They can start becoming more aware of what’s going on in the currency market.

Every time you pull the trigger with your Forex broker, you’ll actually earn some interest. Or you’ll have to pay some interest at the end of the day. When you use leverage, you’re actually borrowing money. When you open 1 standard lot, you’re not using $100,000 of your money. You’re only using $1,000 if your FX broker offers you a 1:100 leverage.

In the first part of the carry trade strategy PDF, we’re going to explain what the carry trade is and how it works. In the second part of the Forex carry trade guide, we’re going to outline the rules for the best carry trade strategy.

What is the Carry Trade?

Let’s talk about what the carry trade is, and how we can take advantage of the difference in interest rates between currencies. Carry trades involve going long on a currency with a higher interest rate. At the same time, you’re going short a currency with a lower interest rate.

The higher interest rate currency is the invested currency. The lower interest rate currency is the funding currency.

When you trade currencies, you simultaneously buy one currency and sell another currency from a different country. Since these currencies have an interest rate attached to them, depending on how you positioned yourself in the market, you’ll either have to pay an interest rate or earn an interest rate.

The interest payment occurs at the end of every business day at 5:00 PM EST, which is when funds rollover.

Basically, the carry trade is a long-term trade that is looking to capture the interest rate. What you need to do is to look at pair selection driven by the interest rate differential. You want to borrow cheap money and put it somewhere where they’re going to pay you a high return on investment for that money.

When a trader is long a currency with a higher interest rate, and short a currency with a lower interest rate, the trader will earn a positive carry. On the other hand, if you hold a currency with a lower interest rate, and you’re short a currency with a higher interest rate, you’ll have a negative carry. In this case, you have to pay the interest rate differential.

The second part of the carry trade strategy PDF will show you how the trade the Best Carry Trade Strategy – The $14 Trillion Tradeworks in real life.

How Carry Trade Works?

Let’s take a look at a real case scenario. At the moment of writing this article, the US interest rate is 2%, while the interest rate in the UK is 0.75%.

The bottom line is that if you would have sold GBP/USD you would earn $4.37 per day. Not quite huge money, right?

Let’s change the way you think about it, let’s think long-term. No one really cares about earning $4 per day.

However, if you held that trade for a year, then those $4 would turn into $1,593. Even if after one year the GBP/USD exchange rate would be at your break-even point you would still make money because of the interest earned.

However, at the end of the day, high yielding currencies also tend to appreciate because of higher demand. You will also be making money from the currency appreciation in which case the interest earned will pale in comparison to the profits made through the positive exchange rate fluctuation.

Forex Carry Trade Strategy

To better understand how Forex Carry Trade strategy works, let’s look at what carry trade strategy is not. The best carry trade strategy is not the type of strategy where the next morning you make massive profits overnight. Carry trading uses a ‘buy-and-hold’ strategy, so it requires a lot of patience and even it requires discipline. Read more about “buy and hold” positional trading strategies here.

You need to find the right market conditions, which is the whole essence of carry trading.

Now, before we go any further, we always recommend taking a piece of paper and a pen and take note of the rules of this scalping strategy.

Step #1: Pick one high-interest-rate currency and one low-interest-rate currency.

If you’re a beginner, we encourage you to stick to the G7 currencies. Avoid the emerging market currencies, which often offer a high yield. A currency like South African Rand, Turkish Lira or the Russian Ruble is more sensitive to any headwinds in the financial system.

When there is risk aversion in the market, investors will usually first sell these risky currencies.

The higher the interest rate differential between the two currencies, the greater the opportunity you have to earn interest.

Additionally, you have to keep in mind that since currencies are leveraged instruments. Every time you open one standard lot you’re basically borrowing money from your broker. Your interest rate will depend on the interest rate differential between the two currencies, how large your position is, the rollover cost and the final swap rate debited or credited to your account. This means your interest rate will be different than the real interest rate differential.

If you want to optimize the best carry trade strategy, then you have to also pick the Forex broker that offers you the most attractive swap rates.

From the above table, we can recognize that the highest net return is offered by going long NZD/CHF. The official benchmark interest rate in New Zeland is 1.75%, while the official benchmark interest rate in Switzerland is -0.75%. This makes NZD/CHF one of the best carry trade pairs 2020.

The currency you’re trading needs to be correlated opposite one another. This way you have a positive carry trade if you go long the high-yielding currency and go short the low-yielding currency.

We also take into consideration other factors when deciding to place a trade based on the carry trade.

Step# 2: The technical trend needs to confirm the positive carry trade direction.

Another factor that makes the carry trade very attractive is the fact that you can also earn money from currency appreciation. So, in addition to the possibility of earning interest, we also look to gain from the currency exchange fluctuations.

If we want to capture the positive carry trade we need to belong to NZD/CHF. But if we want to also benefit from the currency exchange rate appreciation we need to wait to have favorable bullish conditions.

The most favorable bullish conditions are when NZD/CHF trades above the 200-day EMA.

This is also the most common way hedge funds read the trend direction is to use the 200-day moving average.

Next, we’re going to highlight how professional traders manage the carry trade.

Step# 3: When to take profits on the carry trade and how to manage risk.

First of all, the carry trade works best in a risky type of environment. In other words, you need to look for a sentiment or a mood in the market where investors are in the mode of wanting to take on risk.

When you use this as your barometer, you can buy more exotic currencies that have even double-digit interest rates.

The way the smart money thinks is if the stock market is in an uptrend or moving up, then they assume investors are in a risk-taking type of environment. Conversely, when the stock markets turn down, we’re in a risk aversion type of environment and investors will sell risky assets in which case the carry trade will not work.

You need to optimize your carry trade by learning how to read when it unwinds. The carry trade is a buy and hold mentality. But be careful, at some point, the trend will eventually reverse. We can use the 200-day EMA to read when the trend is about to change and close the trade once NZD/CHF breaks below the 200-day EMA.

The NZD/CHF exchange rate traded above the 200-day EMA for 328 consecutive days in which case you would have captured $2,764.35 just from the interest rate.

Depending on your entry point, the maximum profits earned from the currency exchange appreciation is approximately $5,500, earning you a potential profit of $8,264.35

Conclusion – Carry Trade Strategy PDF

The Forex Carry Trade strategy is a common strategy used by many hedge fund managers and institutional traders that are risk seekers. The high yield nature of these currencies is what attracts investors to buy them. Hedge funds need to generate a return on behalf of their investors and the most common practice is to chase higher yields.

This carry trade strategy PDF is like a net cash-grabbing machine because you’ll not just earn money from the carried interest, but you’ll also grab cash from the actual trade. You can build your account much more rapidly with the forex carry trade strategy.

The only downside risk of the carry trade is being caught in a drawdown that winds up in a margin call. This can happen if you put at risk too much percentage of your balance so you need to learn to use proper risk management strategy.

Thank you for reading!

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