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).

The Carry Trade in Forex

The Carry Trade in Forex

Most people starting Forex trading with technical analysis and graduate to combining macroeconomics fundamentals in their trading strategies. However, there is a very different style of Forex trading that involves earning money regardless of which way the market moves, and it is called carry trading.

While any student of finance will be able to instantly identify what carry trade means, let’s elaborate the concept briefly so that the amateur traders among us can get a pretty good idea about what we are getting into.

If you ever kept your Forex positions open overnight, you might have noticed that your broker might have given you a small change in the Swap column of your account statement. Often, your broker might have deducted such Swap interest charges as well.

Carry trade is basically having exposure to currency pairs that offer positive overnight interest rates in hope that if you hold the position long enough, the earnings from interest rate difference would turn out to be a substantial sum. Well, if you are brave enough to utilize leverage, which most carry traders do, holding Forex positions that pay Swap interest can be a lucrative strategy for trading Forex.

How Carry Trade Works

If you borrow or sell a currency that offers lower overnight interest rate and uses the proceed to buy another currency that offers a higher interest rate, your broker will usually pay you the interest rate difference.

Let us provide you with a practical example. Let’s say you are a citizen of Germany and you can borrow €100,000 from a local bank like the Commerzbank in Berlin at 0.5%. Given that currently (as of July 7, 2020), the European Central Bank offers an overnight rate of 0%, theoretically, it is possible to even borrow at a lower rate.

However, let’s assume you are a movie producer and currently living in Los Angeles, and have a bank account in the U.S. Since, the overnight interest rates offered by the Federal Reserve Bank is 2.5%, your bank in California, such as Wells Fargo, would be happy to pay you much higher rate than Commerzbank in Berlin. So, let’s assume that Wells Fargo pays you 2.5%.

Think about it, you can simply convert your €100,000 Euro to $112,258.16 USD (at the market rate of 1 EUR = 1.12258 USD on July 7, 2020) and deposit the entire sum in your Wells Fargo account. Doing so, you will end up earning an interest rate difference of 2.0% per year, which would amount to $2245.16.

Now, if you use 100:1 leverage, that $2245.16 could turn out to be $224,516.32 by the end of the year.

The Risks Associated with Carry Trade

When you first think about it, Carry Trade could appear to be a no-brainer. Nonetheless, there are some inherent risks to carry trading. After all, the price of EUR/USD could go up and at the end of the year when you will have to convert your US Dollars back to Euro to pay back your bank in Berlin, the rate difference can wipe out all of your profits. With leverage, you can easily get a margin call long before the year is over!

That’s why major corporations involved in international trade need to hedge their future transactions to protect themselves from major currency price swings.

While you can Carry Trade and make a decent income from the interest rate difference, keep in mind that if the price of the currency pair goes against you, then you can also end up making a loss.

How You can Carry Trade in 2020

Before you can delve into carry trading, let’s review the current interest rates offered by major central banks around the world.

Country Currency Interest Rate
United States U.S. Dollar 2.50%
United Kingdom British Pound 0.75%
Eurozone Euro 0.00%
Australia Australian Dollar 1.00%
Japan Yen -0.10%
Canada Canadian Dollar 1.75%
Mexico Mexican Peso 8.25%
Turkey Turkish Lira 25.00%

Table 1: Overnight Interest Rates Offered by the Central Banks of Major Economies as of July 2020

From Table 1, you can see that the prospect of making profits from Carry Trade is still a pretty valid idea as some currencies like the Mexican Peso offers an 8.25% overnight interest rate.


Figure 1: MXN/EUR Remained Bullish Since 2020 and Offers Great Overnight Interest Rate

Since the European Central Bank (ECB) has kept its overnight interest rate at 0.00% for a long time, buying the MXN/EUR would theoretically offer a handsome 8.25% overnight interest rate. Another great example of a good pair to carry trade with would be the USD/JPY.


Figure 2: Stable Price of USDJPY Offers a Great Carry Trade Opportunity

Over the last year, the USDJPY price fluctuated between the support near 104.65 and the resistance around 114.35, representing only a 9.27% volatility. Given that the Bank of Japan (BoJ) is offering a -0.10% overnight interest rate compared to 2.50% by the U.S. Federal Reserve, going long on the USD/JPY pair would offer a great carry trade opportunity at the moment.


Figure 3: The Value of U.S. Dollar Went Up by 108.90% Against Turkish Lira in 2020

However, nobody wants to Carry Trade U.S. Dollar vs. Turkish Lira (USD/TRY) despite the 22.5% interest rate difference between these two currencies. During 2020, the value of USD/TRY jumped from 3.3925 to 7.0870, representing a 108.90% increase. So, if you borrowed funds at 2.5% from the U.S. and invested in Lira, you would lose a substantial amount despite the Lira’s higher overnight interest rate.

As you can see, there are more to carry trade than simply calculating the interest rate difference as geopolitics, macroeconomics, and other factors can often dictate the outcome a long-term carry trade.

The Bottom Line

In the days before the sub-prime mortgage crisis that turned into the worldwide The Great Recession, overnight interest rates around the world use to be pretty high. The Bank of England’s overnight rate was above 6.0% and even the Japanese housewives were making a killing with Carry Trade. However, we live in low inflation and low-interest rate environment now and as a result, the appeal of Carry Trade has faded.

Nonetheless, the concept of Carry Trade still remains a viable trading strategy if you are willing to apply it on any currency pair that offers a substantial return on investment and low risk of a directional movement against your open positions.

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