Carry trading is a form of trading where traders take advantage of interest rate differentials between pairs of currencies to make a profit. The most common way of doing this is by buying a currency whose interest rate is high and selling one whose interest rate is comparatively lower.
In such a scenario, the trader gets paid the equivalent of the amount caused by the difference between the two interest rates.
How it works
The concept follows two key steps. In the first step, an investor looks for two currencies with a big difference in interest rates. Secondly, they look for trading opportunities involving either currency that have established a prolonged and stable uptrend.
For instance, the Reserve Bank of Australia (RBA) may raise interest rates to 7%, while the Federal Reserve sets the US interest rate at 3%. A trader can therefore find a trading opportunity involving the US dollar and the Australian dollar. Having realized the 4% difference in interest rates between the two currencies, the trader goes long on AUDUSD.
The investment will bear profit in the form of payments from the broker based on the 4% interest rate difference. The longer you hold on to the trade and the rates favor you, the more you accumulate profits. The catch here is that you have to stay in the interest-positive direction for as long as you are holding on to your long position on the high-interest currency.
Carry trade is mostly used in trading forex but also applies to government-issued bonds as well. For instance, you can borrow money from a country with a low-interest rate and use that money to buy bonds from a country whose yields are higher.
Of course, high bond yields also infers a relatively high-risk exposure, but governments rarely fail to pay their debts. If applied diligently, carry trading can be quite profitable, and you can use it instead of waiting to buy low and sell high.
A working example in forex
Suppose the RBA has set an interest rate of 8%, which is reflected in AUD. At the same time, the Bank of England (BoE) has set an interest rate of 2%, reflected in GBP. A carry trade opportunity would therefore present itself based on the difference in the two interest rates. This can be done by taking a short position on GBPAUD.
Therefore, assuming that the interest rates remain unchanged in England and Australia for an entire year, you would make a profit of 6% if you maintain your position. If you had placed £5000 on that trade, you would make a profit of 6% of £5,000, which is equivalent to £300.
If, however, AUD appreciates during the investment period by 10%, you will make an additional 10% in profit, which is equivalent to £500, bringing your total profit to £800. Similarly, if the AUD depreciates by, say, 10% during that period, you will make a loss equivalent to 6%-10%=4% or £200.
The risks involved
Carry trading is not without risks. The concept is based on profiting from the differences in the interest rates of currencies. Carry trading involves risks associated with high volatility. Generally, the larger the difference in interest rates between currency pairs, the higher the volatility in trading those pairs.
High volatility is a high-risk factor that should be handled carefully by traders because volatile markets can easily turn a profit-making trade into a loss-making one within a short time.
One of the most feared occurrences in a carry trade is the concept of “carry trade unwind,” which is a phenomenon whereby a market may suddenly experience a drastic shift in fundamentals, leading to the rapid appreciation of the funding currency. This can change an otherwise profitable position into a loss-making one.
The advantages
The strategy can yield profits for as long as a trader’s carry trade is in a positive direction. In particular, you can make profits at the same rate as the interest rates differential each day even when the currency pair remains unchanged.
In addition, your profit margin will grow beyond the interest rates if the pair on which you have taken a long position appreciates. It gets even better if you leverage your position and the market moves in your favor because your profits will grow by a multiplier figure.
However, it is generally advisable to keep off leverage whenever you can and especially if you are a new trader. This is because leverage can equally multiply your losses just as it can multiply your profit.
For experienced traders, leverage can pay off quite well. This is because the interest you will receive on a leveraged position is tethered to the amount leveraged and not on the actual amount of capital invested.
For instance, if your position is leveraged to the equivalent of $50,000, and you only deposited $5,000, the broker will pay you the interest as a percentage of the leveraged sum ($50,000) and not the amount invested ($5,000).
In summary
Carry trading is a good strategy for trading forex and also bonds, based on interest rates differential to make profits. The strategy can pay off for as long as interest rates and the currency exchange rates favor you; otherwise, it can be costly.