Yes, we are back with yet another Forex trading lesson, and as we celebrate National Coffee Day, we certainly hope that you will enjoy both this article and a cup of your favourite java!
Today, we are going to focus on a trading strategy that requires traders to have a lot of patience and an in-depth understanding of the economic & political outlook of the currencies traded. Let’s see what Carry Trading is and find out whether it fits your trading style!
What is Carry Trading?
Carry Trading is a long-term trading strategy that focuses on the difference in interest rates between currencies you trade. As you may be aware, every time you hold your position open overnight you are subject to ‘swap’ or ‘rollover’ charges. Carry Traders aim to benefit from these charges, so once the position they entered is closed, the interest rate differential is in their favour, and they will be credited these outstanding fees.
This strategy requires traders to buy (go long) a currency with a higher interest rate while selling (shorting) a currency with a lower interest rate. This means that the currency with a lower interest rate is considered a ‘funding’ currency. You ‘borrow’ a currency at a lower interest rate and ‘invest’ it into a currency with a higher interest rate. The difference in the interest rate will be in your favour. After a considerable amount of time (months to years), it will become a substantial amount due back to you once the position has been closed!
However, you have to remember that not all trades will earn you interest! If your ‘funding’ currency is of higher interest, you will have to pay the ‘rollover’ fees when you close off your position.
So how does Carry Trading work?
Once you have done your research and learn about different levels of interest rates and the general outlook of the economies, you will look to enter a trade. Historically, the Japanese Yen or Swiss Franc were considered ‘cheap’ currencies and were paired with currencies that have higher interest rates, such as the Australian or New Zealand Dollar, creating an interest rate differential in favour of the trader.
For argument sake, let’s assume that New Zealand Dollar (NZD) has an interest rate of 5%, while the Japanese Yen (JPY) has an interest rate of 1%. The interest rate differential is therefore 4%. As such, the trader is looking to go ‘long’ on the NZD/JPY pair. The trader will receive 5% from going long on NZD and will have to pay only 1% from shorting JPY. As a result, s/he will earn an annual carry of 4% for each day the position was open. However, you have to always remember that your brokers spread has to always be taken into account when trading. Your final interest rate differential will be affected by these. This interest is accrued at the end of every day when the markets close (10 PM BST).
It is also important to remember the risks involved in Carry Trading. Ideally, you’re looking for a pair with a long-term uptrend to minimise losses that can result from the market going against your position. As a carry trader, you are mainly looking to gain profit from the interest rate differential. This means that you can even close your position at breakeven and still be in profit due to the interest rate earnings. However, you can also profit from the value increases of the currency over time (when you’re in a long position) - just like with any other strategy!
Unfortunately, if the price moves against you, it is possible to lose money regardless of the amount of the interest rate accrued. If you were unfortunate to hit your Stop Loss you will be liable for losses. However, your final loss would be reduced by the profits you made from the positive interest rate differential. So it is important to always stick to risk management and have an in-depth understanding of the fundamental and technical set-ups for your trades.
We hope that you have enjoyed our brief introduction to Carry Trading and will join us next week as we are going to look into Automation in Forex and the use of Expert Advisors!