Using the currency carry trade strategies

We’ve already explored the idea of carry trades in the previous lesson. The concept is simple enough: traders use this technique in an attempt to profit from the interest rate differential – which you may now know is called ‘rollover.’

This lesson will explain FX carry trades further through examples. We’ll also explore popular carry trade strategies and how you can try to incorporate them into your trading plan.

What’s a currency carry trade and how does it work?

A carry trade involves borrowing a currency in a country that has a low interest rate (low yield) to fund the purchase of a currency in a country that has a high interest rate (high yield).

The idea behind it is to hold such positions overnight in the hope that an interest payment will be made to you based on the ’positive carry’ of the trade.

The lower yielding currency is referred to as the ’funding currency’ while the currency with the higher yield is referred to as the ’target currency.’

As you would’ve learned in the previous lesson, this is facilitated by rollover rates.

As a reminder, this is when your broker either debits or credits your account based on the direction of the open trade (long or short), and whether the interest rate differential is positive or negative.

Since interest is quoted as an annual figure, these adjustments will be the daily adjusted rate for each day you leave your positions open ‘overnight.’

Remember, interest rates are set by a country’s central bank in accordance with the mandate of its local monetary policy. This will differ from country to country.

In a carry trade, your aim is to earn interest on a currency you’re ‘long’ on, which would be the one with the higher interest rate.

There are two main components to FX carry trades:

1. Changes in interest rates

The main component of carry trades is centered around the interest rate differential between the two traded currencies.

For example, if the Australian dollar has an annual interest rate of 4% and the Japanese yen’s rate is set at 0%, you could look to buy (long) AUD/JPY to take advantage of the 4% net interest rate differential.

Even if the exchange rate between the two currencies remains unchanged, you’ll likely profit from the overnight interest payment. However, central banks tend to alter interest rates over time, and this poses a potential risk to this strategy. In short, there’s potential for the interest rate differentials to go against you on the same trade you previously benefitted from

2. Exchange rate appreciation/depreciation

The other component of the carry trade strategy focuses on the exchange rate of the two currencies in the pair you’re trading.

If you’re long on a pair, you’re hoping for the target currency (the base currency) to appreciate. When this happens your payoff would include the daily interest payment and any unrealized profit from the currency.

However, the profit you might make, as a result of the target currency appreciating, will only be realized when you close the trade.

It’s possible to lose money when the target currency depreciates against the funding currency in that the capital depreciation wipes out any positive interest payments.

The risks involved with carry trades

The financial markets can be volatile. So regardless of how prepared you might be, you still run the risk of losing money – even with a strategy in place.

Currency carry trades, like most trading strategies, also have a degree of risk. When you use this strategy, you may also want to consider adopting sound risk management measures as well.

Risk management has perhaps become even more important since the 2008/09 global financial crisis, which resulted in lower interest rates for developed nations.

Because carry trades largely depend on interest rates, a trader in this situation might want to look to high yielding emerging markets currencies (which often carry a lot of risk) until interest rates normalize.

Among other downsides associated with trading the markets this way, this strategy also carries these risks:

• Exchange rate risk: should the target currency weaken against the funding currency, you could see the trade move against you but still receive the daily interest
• Interest rate risk: if the target currency’s interest rate decreases, and the funding currency’s increases, the positive net interest rate is likely to reduce and thus affect the position’s potential profitability

An example approach to carry trade strategy

Filtering FX carry trades in the direction of a trend is one of the strategies experienced traders tend to use. This is because carry trades are normally held over the long term, making them useful for analyzing markets that exhibit strong trends.

In an attempt to get into higher probability trades, you might want to analyze the markets chart data to find the uptrend – which, in the chart below, is confirmed after the higher high and higher low.

The figure depicts higher highs and higher lows whereby a break of the horizontal line (drawn at the first higher high) confirms the uptrend. Thereafter, traders can make use of multiple time frame analysis and indicators to spot ideal entry points to enter a long trade.

CONCLUSION

Currency carry trades present traders with two avenues to profit (exchange rate and interest rate differential) but it’s essential to manage risk as losses can arise when the pair moves against traders or the interest rate differential narrows.

For higher probability trades, traders should look for entry points in the direction of an uptrend and should protect downside risk by utilizing prudent risk management techniques.