Carry trade: a good trading strategy?
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What is carry trade?
Carry trade is a Forex transaction that takes advantage of the interest rate differential between two currencies. Each central bank sets its own key interest rate for its currency. By buying a currency, you receive the interest rate on your trading account and if you sell it, you pay the interest rate. The purpose of a carry trade operation is therefore to buy a currency with a higher interest rate than the currency you are selling. On Forex, buying or selling a currency pair always involves two simultaneous transactions: buying one currency and selling another. To win with a carry trade, you therefore need to find the most advantageous currency pair.
How to find the right currency pair for a carry trade
At first glance, a carry trade always seems simple. You tell yourself that you just have to look at the interest rates table of the different central banks; "I’ll choose the currency with the highest interest rate and the one with the lowest rate, and I just have to buy or sell the pair to get the rate differential". I'm going to shatter some dreams by telling you it's not that simple!
Why? Winning on a carry trade transaction is one thing but for the trade to remain a winner, the asset’s trend must also be in line with your transaction. Let's take an example (totally imaginary). The interest rate on the Euro is 5% and that on the Dollar is 0.5%. If you buy EUR/USD, you will receive 4.5% (5-0.5) annually. If during the time you holdyour trade, the EUR/USD loses 10% of its value, you will lose out on the trade. Indeed, you gain 4.5% on the carry trade but lose 10% on your trade. In the end, the operation loses 5.5% (10-4.5).
How can the trend of a currency pair go in the opposite direction to my carry trade transaction? The trend of a pair is not only a function of interest rates (see page factors influencing exchange rates). In other words, a currency with a high interest rate will not necessarily appreciate against other currencies. Conversely, a currency with a low interest rate will not necessarily depreciate on Forex. The opposite is often the case.
Generally speaking, if a currency has a high interest rate, it is because the central bank wants to fight inflation (which depreciates the currency) or attract investors with an attractive interest rate (economy ignored by investors). If a currency has a low interest rate, it is because the central bank wants to revive its economy (recession or weak growth).
It is therefore difficult to find a good carry trade transaction. First of all, you need a currency pair with an attractive interest rate differential (to affect swap transactions every day) but also one with a trend moving in the direction of your carry trade transaction. Do not look for opportunities with too large an interest rate differential, the pair's trend will often go in the opposite direction to the carry trade transaction. A good carry trade is a compromise between the pair's trend and its interest rate differential.
A carry trade transaction is comparable to a share purchase on a stock exchange for the purpose of receiving dividends. The dividend may be attractive but it is not enough to motivate the purchase. The share price must not fall too much, otherwise you will lose out on the transaction.
Carry trade tips
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Duration for holding the trade
: If you perform carry trade transactions, it means that your investment horizon is long term. The differential between two interest rates is annual. If you keep your position only a few days, you will simply receive the differential *n/365 (n representing the number of days). On a short term trade, interest rates should not influence your position (based only on bullish/bearish signals).-
Entry point
: As with all Forex trading, you need to take care with your entry point. If you buy/sell at a higher/lower price, your performance will be strongly impacted (positively or negatively). Carry trading therefore requires technical analysis on the chosen currency pair. You can do a first analysis on a weekly chart to identify the trend and optimize your entry point by performing analysis on a daily chart.-
Don't mistake the objective
: The objective of a carry trade is to take advantage of the interest rate differential, not the currency pair trend. The important thing is that the price does not cross your entry price in the long term. No matter how the price moves, time is your ally. Every night you receive the swap trades, which generates performance. If you have signals (bullish/bearish) in the opposite direction to your trade, it does not matter as long as your entry price is not crossed.Risks of carry trades
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Monetary policy change
: If interest rates move in the wrong direction, your carry trade transaction can be put at risk. A change in trend can be very sudden! A lot of hedge funds carry trade. If the spread narrows between two currencies, the funds may decide to unwind their positions massively. This is what happened on the USD/JPY a few years ago. Everything was going well in the best of worlds (bullish trend on the pair + positive rate differential) and then the subprime crisis came along. As a result, the FED lowered its rates (making the carry trade operation less attractive) and the funds unwound their positions. In just over a year, the USD/JPY pair went from 124 to 98 points. Add to this the fact that the carry trade operation has become less profitable with the fall in rates. Many hedge funds have gone bankrupt!-
Money management
: With carry trades, positions are long term. Changes in a currency pair are measured in hundreds of pips. So you need to be able to manage your risk properly. With too much leverage, the slightest turn could be fatal! Money management does not allow you to risk too much of your portfolio on a position. If your account is too small (less than €1,000), don't even hope to carry trade. I advise you to take a look at the page: Money management on small Forex accounts.-
Change in the asset’s trend
: The trend of a currency pair depends on many criteria. It only requires one of the factors to change to tip the trend in the other direction. If the trend reverses, the carry trade operation may no longer be profitable in the long term. Hence the importance of being careful with your entry point!Conclusion
A carry trade can be very profitable if you benefit from both the interest rate differential and the asset’s trend. However, the risks associated with the use of this strategy are significant and having a macroeconomic vision over the long term is necessary. The success of a trade is largely related to the level of your entry point. Carry trades are not available for small accounts and are more reserved for experienced traders. In other words, if you're reading this sheet, you're not ready to carry trade!
