eToro – Forex Trading Forum

[djsheckie]

Now matter what your investing strategies if you've been trading for any length of time you've probably at least heard of carry trading. So what is it?

Generally the carry trading strategy has been profitable since the 80s. However, only in recent years has carry trading received any real media attention. For those who are still scratching their heads in consufion, don't worry I'll lay out how carry trading works. You can call it Carry Trades for Beginners. First we'll cover the structure of a carry trade, when it works, when it doesn't and the ways carry trades can be carried out in different styles.

[djsheckie]

Carry trading is one of the most favored trading strategies used when trading FOREX. How is it carried out? Basically, carry trades involve nothing more than buying a high yield currency and funding it with a low yield currency.

When creating carry trades the most popular currency pairs are: Australian dollar/Japanese yen, New Zealand dollar/Japanese yen and the British pound/Swiss franc. Why? These pairs are favored because the interest rate spreads of these currencies pairs are very high. The first step in putting together a carry trade is to find out what currency offers a high yield and what one offers a low yield.

[djsheckie]

The interest rates for the most liquid currencies in the world are as follows:

Central Bank Rates

NZD 3.00%
AUD 3.25%
GBP 0.50%
USD 0.25%
CAD 0.50%
EUR 1.50%
CHF 0.25%
JPY 0.10%

Not sure where to find the interest rates? You can keep track of and and stay on top of the interest rates for the various currencies by checking the websites of that nation's central banks. So, now that we can see that New Zealand and Australia have the highest yields on our list while Japan has the lowest, it isn't much of surpise that AUD/JPY is bascially the poster child of carry trades. As you shouold already know if you're trading currencies are traded in pairs. Therefore, all you need to do is buy whatever pair, be it - NZD/JPY or AUD/JPY on eToro and watch your profit roll in.

[djsheckie]

Another aspect that traders take advantage of is a low selling cost. The Japanese yen's low cost has increased it's popularity with a number of traders over the years. In fact, in the last few years, the carry trade has finally expanded beyond the FOREX world where it originated. Other traders have begun placing on their own variations of the carry trade by shorting the yen and buying U.S. or Chinese stocks. You should know that this expansion has created a huge speculative bubble in other markets and created a strong correlation between carry trades and stocks.

How Intrest is Earned on Trades

One of the cornerstones of the carry trade strategy is the ability to earn interest.

[djsheckie]

So if interest is a cornerstone then it only makes sense to see how interest is calculated. This is a rough overview but bascially daily interest is calculated using this formula:

(Interest Rate of the Currency that you are Long – Interest Rate of the Currency that you are Short) x Notional of Your Position
# of Days in a Year

Example:

If you have 1 lot of of a currency pair (let's say the interest rates are 8% and .5%) that has a notional of 100,000, we compute interest the following way:

(.8 – 0.005) x 100,000 = approximately $20 a day
365

However, just know that this is the amount that can be earned ONLY by traders who are long on the trade.

[djsheckie]

Carry trading is a fairly basic strategy but that doesn't mean it isn't profitable. If you follow the Australian dollar/Japanese yen pair (AUD/JPY) from Jan 2000 through May 2007 you'll see that the pair produced (on average) an annual return of 5.14%. For some traders, this yield would hardly be worth noticing, however in a market like FOREX where you can find leverage as high as 200:1, even the use of five to 10 times leverage can make that return extremely extravagant.

Also, in theory traders could earn this return even if the currency pair fails to move at all. However, you certainly shouldn't count on that.

[djsheckie]

So, over the course of about six and and a half years, the AUD/JPY exchange rate increased 83%, bringing the return on a long AUD/JPY trade to 100%. At two times leverage, that's 200%.

Before you get too excited though know that there are some complications to consider when using carry trading as a srategy. Carry trading isn't only about going long with a currency that has a high return and shorting a currency with a low return. IIt doesn't take long to realize that carry trading would fail instantly in a situation where the exchange rate devalues by more than the average annual yield.

[djsheckie]

On the same note if you make use of leverage, your losses could be even more devastating. This is why if a large carry trade goes wrong, the liquidation can be devastating. So, with this in mind it is critical to understand the situations were carry trades work and the times when they fail.

Situations Where Carry Trades are a Good Idea:

The Central Bank Increases the Interest Rate: Carry trading works well when central banks are either planning to increase their rates or have already increased them. Since currencies can now be moved across borders and around the world at the click of a mouse, and big investors are not hesitant to move money from one country to another in search of not only high, but also increasing, yield.

[djsheckie]

So why does raising the interest rates help?
The appeal of carry trading isn't just in the returns it can generate, but also the capital appreciation. When a central bank raises its interest rates, the everyone takes note. This typically leads to many traders jumping on the bandwagon and carrying out the same carry trade. This benefits those involved by pushing the value of the currency pair higher in the process. However, it important to keep in mind that for the best results you'll need to make an effort to get into the trade at the beginning of the rate tightening cycle and not the end.

[djsheckie]

Carry trading works well in low volatility environments simply because traders in such an environment are more willing to take on risk.

The primary thing carry traders are looking for is the yield if there is any capital appreciation its seen as an added bonus. Therefore, most carry traders are actually perfectly happy if the currency does not move one penny, because they will still earn the leveraged yield. So long as the pair doesn't drop, carry traders will essentially get paid while they wait. Also, traders and investors are generally more willing to make riskier moves when they're in low volatility environment. When they take on risk, it has become a habit to fund these riskier trades with short yen positions.

[djsheckie]

When Central Banks Lower Their Interest Rate: Carry trades may not end up profitable when countries with higher rates decide to cut interest rates. This shift in a nation's monetary policy often indicates a major shift in that currency's trend. The key to pulling off a successful and/or profitable carry trade is for the pair you're trading to either not change in value or or for its value to increase.

Often when the interest rates are lowered, foreign investors are generally less likely to go long the currency pair and are more likely to look elsewhere for more profitable opportunities.

[djsheckie]

Obviously, when this occurs, the demand for the currency pair has declined and so it begins to sell off. This in turn leads to a depreciation in the currency pair and could quickly and easily wipe out any interest income.

The Central Bank Involves Itself in the Currency: Failure may also occur if a central bank deem it neccesary to intervene in the FOREX market. This is usually to either stop the currency from rising to much or prevent it from losing further value. In the case of countries that are export dependent, an currency that's doing too well may discourage their sale of exports because of higher prices whereas an excessively weak currency could lead to significant backlash.

[djsheckie]

This scenario is especially true when talking about the Yen. The Japanese Yen is the preferred currency for funding trades, however many companies overseas often grumble and complain that the weakness in the Yen is making their higher priced goods less competitive in the global market.

These same companies also lean on their own politicians to put pressure on the Japanese to either increase interest rates or intervene in the currency to prevent it from falling even more. Either of these tactics would strengthen the yen, which would bring down the exchange rate of carry trades. This would also be true of any intervention by the Reserve Bank of New Zealand to weaken the value of the New Zealand dollar.

[djsheckie]

The Best Strategy for a Trade Carry is Using a Basket

So now that you know the pros and cons of carry trading keep those in mind as we the best way to trade using the carry. Usually the best method for carry is using a basket.

Why? When it comes to carry trades, at any point in time, one central bank may be holding interest rates steady while another may be increasing or decreasing them.

How does a basket help? By using a basket (i.e. - using the three highest and the three lowest yielding currencies) that means that one of the currency pair only represents a portion of the whole portfolio; therefore, even if there is carry trade liquidation in one currency pair, the losses are controlled by owning a basket.

[djsheckie]

Using a basket for carry trading is how investment banks and hedge funds make their trades. However, you should know that while this strategy is great for institutions it can be a little difficult for individuals to implement since trading a basket obviously requires more money upfront. However, you should know that it is possible to make carry trades using smaller lot sizes. The main point to keep in mind when trading with a basket is to dynamically change the amounts allocated in the portfolio using an interest rate curve and by following the monetary policies of the central banks to find the most profitable arranegment.