A carry trade is a financial strategy that is widely used by forex traders to attempt to collect profits daily. It involves the following process:
· Borrowing funds in a currency with low interest rates.
· Using the funds to buy another currency with higher interest rates.
· Collecting the fee that is generated each night due to the difference in interest rates.
This is done with the aim of profiting from the difference in interest rates between the currencies, which is known as the interest rate differential or the net carry.
While this is an approach that can generate positive returns from the interest rate differences, we need to bear in mind that exchange rate fluctuations can generate either profits or losses. We’ll be looking at exactly how carry trades work and what risks you need to be aware of.
What Is a Carry Trade and How Does It Work?
To explain carry trade mechanics, we need to consider that every currency pair that’s offered on the forex market has an overnight financing cost. This is known as the rollover or swap rate, and it varies according to the difference in interest rates between the central banks that issue the two currencies.
Trading forex is all about buying a particular currency and selling a different one. To use the carry trade method, you use a currency with low interest rates as the funding currency, which means that you sell or borrow it.
The Japanese Yen and the Swiss Franc are among the currencies with traditionally low interest rates. However, you should always check the current interest rates and market predictions before choosing this currency.
The target currency is one with a higher interest rate than the ones we just looked at. This is the currency that the trader buys to benefit from its better interest rate. It often includes those in emerging markets, while the Australian Dollar has historically been a common choice.
When you hold this position overnight, you get paid the interest differential. This is where the profit comes from, but we also need to take into account any exchange rate movements. However, the key risk is that you need the exchange rate to stay stable or else move in your favour.
Learn more about how interest rates affect currency prices to understand the effect of interest rates.
Why Interest Rate Differentials Matter in Carry Trades
The fact that interest rate differences are found across a range of currencies is the key reason why carry trades exist. This is what creates the opportunity, so it’s vital that we look at the factors that affect these rates.
Central bank decisions are among the main factors that need to be taken into account. If the central bank decides to raise or lower its interest rates, this has an immediate effect on the viability of carry trades using its currency.
Traders often look for a stable interest rate to let them use this strategy effectively. This is because stable rates mean that the trader can focus fully on earning from the interest rate differential without expecting any rate fluctuations to complicate matters.
The importance of stable exchange rates and differing interest rates provides a strong reason for understanding the potential changes from central banks.
Carry Trade Risks and Reverse Carry Trade
Before opening any carry trades, there are a few risks that traders need to take into account. They include the following points.
· Unexpected interest rate changes may occur
· Market uncertainty could affect the trade
· Sharp currency movements may lead to profits or losses
Any of these risks can reduce or remove profits in a short period of time. It's vital to learn the basics of risk management for traders to keep the risk level under control when trading.
Let’s say that you decide to use the Japanese Yen and Australian Dollar for a carry trade. If either of the central banks changes its strategy, you need to decide whether the transaction still makes sense. You may decide to close the carry trade if you feel that the risk vs reward ratio no longer justifies it.
At some point, traders also carry out a reverse carry trade or unwind. This is when the trade is closed, and the position is reversed. It’s a process that is typically carried out when market conditions change, or the interest rates or exchange rates vary.
This may be done in a hurry when the market moves unexpectedly. It’s also the way to close a position when you simply want to move the funds elsewhere.
When Traders Use Carry Trade Strategies
Carry trades are used in specific market conditions, usually when traders feel that the market is stable and interest rate policies are predictable. In these conditions, a carry trade position may often be left open for a long time, gathering interest every night.
However, it’s important to note that traders who use this strategy combine it with broader market analysis. They don’t rely simply on interest rates. It’s a type of forex trade that needs to be considered carefully, rather than being the straightforward choice that it appears to be at first sight.
Carry Trade FAQs for Beginners
Is a Carry Trade Strategy Suitable for Beginners?
Generally speaking, no. The basic idea seems simple, but not every beginner is going to be comfortable handling the risks involved in this strategy. Rather than viewing it as a simple high-yield savings account, it needs to be viewed as a leveraged currency trade that can fluctuate widely.
What Currencies Should I Choose for Carry Trades?
The starting point is to identify one currency with low interest rates and another with higher interest rates. While there are some popular options to be aware of, you also need to understand that interest rates can vary, so you have to look out for changing conditions.
Do I Need to Carry out a Reverse Carry Trade At Some Point?
Yes, this is the way that you close a carry trade position. It means simply carrying out the opposite process from the one that you used to open the position.
Are Carry Trades Risky?
Yes, this type of trade involves a degree of risk. This is mainly due to the possibility of exchange rate volatility, with any leverage used in the trade amplifying the size of any swing in the market conditions.
The information provided does not constitute investment research. The material has not been prepared in accordance with the legal requirements designed to promote the independence of investment research and as such is to be considered to be a marketing communication.
All information has been prepared by ActivTrades (“AT”). The information does not contain a record of AT’s prices, or an offer of or solicitation for a transaction in any financial instrument. No representation or warranty is given as to the accuracy or completeness of this information.
Any material provided does not have regard to the specific investment objective and financial situation of any person who may receive it. Past performance is not a reliable indicator of future performance. AT provides an execution-only service. Consequently, any person acting on the information provided does so at their own risk.