Carry trading is a well known trading strategy where a trader will sell a currency with a low interest yield and in exchange buy a currency with a high interest yield. This is also sometimes referred to as being “long the carry” trade which means a trading position is able to earn interest.
- Simple fulfillment - rate differences higher than trade cost.
- Increased demand can raise currency value.
- Yen-NZD carry over 7%
- Long-term trading strategy.
A trader is able to learn the difference between the interest rates, which can be especially amplified with the amount of leverage often involved in currency trading. The carry trade is also frequently used by investors to finance the purchase of other securities. Investors will borrow a low yielding currency at an inexpensive rate and use it to buy another currency, for example the US dollar, which they finally use to purchase securities such as stocks. This gives the investor the ability to not only make potential gains on the securities but earn interest on the carry trade.
Over the past several years, carry trading has become an increasingly discussed topic by investors as the global markets have become more connected. It is often mentioned on market news channels and the correlations between other markets are extensively discussed. Carry trading is a strategy that a large percentage of successful traders choose to use because it is simple to follow as it is based on the fundamental economic law of supply and demand. Supply and demand makes up the principal behind carry trading as capital generally flows into economies with higher interest rates as investors are always looking for larger returns on their investments.
For example, if two banks were to give the option of putting savings into their accounts but the first is only offering 1% interest per year and the second is offering 10%, which bank will receive the most deposits? The one that is offering 10% would definitely have the highest number of deposits. Also, when carry trading is done under appropriate market conditions, it will not only allow a trader to profit from the interest yield but also from the appreciation in the currency as demand for it is higher.
A Carry Trade Example
The Japanese yen (JPY) is currently considered to be the most popular currency to use as the low interest yielding currency in the carry trade because it is the lowest of the G8 nations at 0.5%. If a trader were to sell the JPY and use it to buy the New Zealand dollar (NZD), also know as the kiwi, which is currently at an 8.25% interest rate, the differential would equate to 7.75% (8.25% - 0.5%). On an investment of $1,000, a trader would be able to earn 7.75% on that carry trade per year, which is $77.50. When a relatively conservative leverage of 10:1 is taken into account, the trader actually earns 10 times that amount per year: 77.5% or $775.
This clearly shows why carry trading is such a popular form of trading strategy. One important thing to note is that these gains are solely based on interest and do not take actual rate fluctuations over the year into consideration. Secondly, leverage is considered to be a double edged sword; while it can maximize a trade’s gain it can also maximize its losses. It is also important to know that if trading against the carry trade, which means to buy the lower yielding currency, interest will be paid on the trading position.
A great way to decide if carry trading is a strategy worth pursuing is to test it on a free forex practice account. At FXCM, for example, the amount of interest rollover is paid out every day of the trading week at 5pm EST when your positions are automatically rolled into the next trading day. Traders even receive interest for Saturday and Sunday on the prior Wednesday when so-called "triple rollover" occurs. The rollover amount is also very simple to find on the trading station so the amount of interest that will be earned or paid is very transparent, depending if you are long or short the higher yielding currency.
Like all trading strategies, the carry trade is best used under certain market conditions as interest rates alone are not the sole factor that influences its success. When investors have a lower risk aversion, they are more interested in investing in higher yields and therefore the carry trade is optimal. In a high risk aversion environment, carry trading should be avoided because, although one will still earn daily interest on ones positions, the losses that can occur due to the currency depreciating can all but eradicate any potential profit. Overall, carry trading is a long-term strategy, and traders should look to keep trades open for at least 6 months as this will also ensure that the trade will not be affected by short-term price movements.
