How to use the currency carry trade strategy

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By :  ,  Financial Writer

What is a carry trade in forex?

Carry trades are a forex trading strategy that seeks to capitalize from the interest rate differential between two currencies within a currency pair. Also known as a forex currency trade or carry-on trade, this strategy can apply to both long and short trades given the interest rate differential is strong.

For example, a long carry trade involves borrowing a low-yield (low interest rate) currency to buy a higher-yield (high interest rate) currency and profiting from the difference in interest rates. The Australian dollar/Japanese yen and New Zealand dollar/Japanese yen are popular forex carry trade pairs because of their high interest rate spreads.

It is essential to bear in mind that while interest rates are typically quoted on an annual basis, they can fluctuate at any time due to central bank decisions. However, some countries seek to maintain a stable interest rate for an extended period in accordance with their economic policy, allowing traders time to profit using carry trades. Typically, a currency carry trade is kept open for several months.

At face value, forex currency trades may seem like a low-risk strategy, but there are pitfalls you should be aware of. For example, a minor depreciation of the target currency can be enough to quickly erase any gains from the interest rate differential. Carry trades are usually most effective when the currencies you’re using experience low volatility.

How does a currency carry trade strategy work?

The currency carry trade strategy works by exploiting different rates of currency appreciation driven largely by inflation and interest rates. In a carry trade, you borrow a low-yield currency to buy a higher-yield currency, allowing your funds to appreciate faster than if they were denoted in the low-yield currency.

When to enter and exit currency carry trades

Traders usually   time their entry and exit points for a carry trade with the anticipation of interest rate hikes, preferably slightly before its announced by a central bank. These announcements help drive demand for the currency, pushing its value even higher.

On the other side, if inflation for a currency is cooling off and traders believe the central bank might lower the interest rate, it might be helpful to get out early. Once the announcement is made and interest in a currency lessens, selling off the currency becomes more difficult. Spreads for closing trades could widen, eating into profits.

Overall, traders should stay aware of central bank announcements and monitoring statements from those official to hopefully predict future rate announcements.

How interest rates work in forex

Forex interest rates, also known as rollover rates, are charged as daily fees for holding your positions overnight. These interest rates can be negative or positive, so they’re important to consider in any forex trading strategy, not just carry trades.

Rollover rates are based on current interest rates set by central banks. They tend to be stable during normal market conditions but can change drastically overnight if the interbank market becomes stressed or central banks decide to change rates. It’s useful to keep a calendar of central bank rate decisions on hand so you’re not caught off guard.

Rollover rates are executed at 5 pm ET because the New York trading session is usually seen as the last, with the Sydney session ‘opening’ the next day. The forex market is open 24 hours a day, 5 days a week, closing at 5pm ET on Friday and opening again on Sunday at 5 pm ET . To account for the closed days, Wednesday’s rollover rate is tripled. 

Best carry trade forex pairs

The forex pairs for carry trades involve currency pairs wherein one currency has a high-interest rate, and the second currency has a low-interest rate.

Two popular low-interest rate currencies for currency carry trades are the Japanese yen (JPY) and the Swiss franc (CHF). Traders have more options when it comes to high-yield, or high-interest rate, base currencies.

Popular high-interest currencies include the Australian dollar, US dollar and the euro. Countries whose currencies are experiencing high inflation often raise interest rates in an attempt to combat inflation. Other currency pairs that represent stable economies and low-risk countries include USD/CHF, USD/JPY, CAD/CHF, and NZD/CHF. These are all examples of currencies pairs with high interest rate spreads and stable economies.

Best carry trade pair for 2023

Since the global financial crisis of 2008, carry trades have been difficult to execute due to low interest rates implemented by central banks. However, recent years have seen central banks raise interest rates to curb high inflation, bringing a renewed interest to the fx carry trade.

For example, the interest rate spread between USD/JPY is expected to reach 5.00% by the end of 2023. This could provide a prime opportunity for forex currency traders to execute a carry strategy.

Keep reading to learn more about the fx carry trade strategy so you can take advantage of rising interest rates. Of course, there are still dangers to be aware of if the USD depreciates too much against JPY and eradicates potential gains. Risk management is essential to all forex trading strategies.

How to make a carry trade in forex

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Currency carry trade example: JPY carry trade

In this example we will show how a long Japanese yen carry trade works with USD/JPY, a popular currency pair for carry trades. At the time of this article, the Fed has set a 5.5% interest rate while the Bank of Japan effectively has a 0% interest rate.

To capitalize on the 5.5% interest differential, you would sell JPY to buy USD. To keep it easy you buy 100,000 USD with 9,000,000 JPY at an exchange rate of 90 JPY = 1 USD.   

As long as the spot rate remains constant, you will gain 5.5% interest on your position after one year. That means your position grows to 105,500 USD. That’s a gain of $5,500. This USD JPY carry trade can be even more lucrative when you trade on margin. A 20:1 margin requirement, or 5%, means you only need ¥5,000 JPY to open a ¥100,000 JPY position, making the $5,500 gain a 70% profit. Margin requirements vary for each currency pair, you can view all margin requirements here

Of course, any change in the spot rate of USD/JPY can impact your trade. If the exchange rate moves to 85 JPY = 1 USD when you close your trade, you’ll only receive ¥8,797,500, a smaller amount than you opened the trade with. The carry trade strategy is fairly simple, but this is one of several risks that can ruin the method.

Risks of carry trades

Currency carry trades hold two main risk you should stay aware of when planning your strategy. When setting proper risk measures like stop-loss orders, you should consider all possibilities that might cause your carry trade to move against you.

Exchange rate risks

The forex market is known for its volatility, and there are many factors that can affect a currency pair’s exchange rate. It only takes a change in one economy to move an exchange rate against you during your trade. When that happens, the profits you’ve built up in your open trade can easily be wiped out before you’re able to close the position.

Interest rate risks

Because carry trades rely so heavily on wide interest-rate spreads between two currencies, any change made to either currency’s interest rate can drastically affect your trade.

For example, the Japanese yen is a popular funding currency for carry trades because the country seeks to maintain near-zero interest rates. But during the credit crisis of 2008, interest rates for high-yield currencies like the euro and US dollar were slashed. Japanese investors who normally focused on overseas investments pulled out of those international markets to reinvest in the yen. This caused the nation’s currency to appreciate, and consequentially made Japanese yen carry trades unwind as the interest rate differential between yen currency pairs became insignificant. Ultimately this unwinding caused the exchange rates to reverse.

Benefits of carry trades

FX carry trades have several advantages beyond the addition of interest earnings on top of your trading gains. The interest payments made by your broker are on the leveraged amount, so if you open a trade for one lot (100,000) you may only need $2000 depending on your broker’s margin requirements. However, the interest paid by your broker is on the entire $100,000, not just the $2000 of your own funds.

Carry on trades can give you consistent returns if markets stay stable, which makes the strategy viable when market volatility is low. However, as with any forex trade comprehensive risk management is essential. You should always establish stop-loss and take-profit orders in alignment with your trading strategy when executing fx carry trades.

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