The Carry Trade Strategy works by selling, or “lending” (go short) a currency with a low interest rate; and buying (“borrowing”) a currency with a high-interest rate. Right now the CHF, JPY, and EUR have the lowest interest rates, while the NZD and AUD have the highest rates. We showed this in the table in the first few pages of this course, so consider these currencies if you want to use this strategy.
Carry trade is an effective system for profits when the market is “resting”. Potential profits derive from the differential (difference) between both currencies’ interest rates, and the expectations for future changes in those two interest rates. That is to say, part of a trader’s considerations when choosing a pair to “carry trade” will be his expectations that in the short run, changes in the interest rate of one or both of the currencies of the pair will occur. If the differential grows, the trader earns, and vice versa.
Say you go to the bank and ask for a $20,000 loan. The bank approves at an annual 2% interest. With all the money you borrowed, you purchase bonds for investment, which will produce an annual 10% interest for you.
Nice, wouldn’t you think? That is how Carry Trade works.
Carry Trade catches are very popular among experienced traders. There are more than a few brokers who offer this service automatically on their platform.
Traders must be cautious of unexpected interest changes in developed economies, third-world countries, and unstable periods.
Important: This system is usually efficient for “heavy” players and big money speculators, who invest a great deal of capital, wish to produce nice earnings on interest rates.
Forex Trading Strategy Example:
Let’s assume that you have $10,000 for investment. Instead of going to your bank and maybe getting 2% annual interest ($200 per annum), you could invest your money in Forex and go Carry Trading on a chosen pair. Based on what you have learned about leverage, you can choose to leverage your $10,000 reasonably- leverage it 5 times. Your $10,000 is now worth $50,000. OK, pay attention now: you have opened a position worth $50,000 with an actual $10,000. Assume that during the next year, the differential ratio will be 5% (in other words, the difference between the interest rates of the 2 instruments of your chosen pair will expand by 5%). You would earn $2,500 a year! (2,500 is 5% of 50,000) Just by investing in interest rate changes and ratios. $2,500 is 25% of your original, initial investment on this position!
There are 3 possibilities here:
- If the currency you are buying crashes and loses value, you would lose your investment (regardless of the “carry trade” system. You would lose because the currency has lost more value than what you would earn from the interest rate difference).
- If the traded pair more or less keeps its value, having a stable year without changes, you will profit from the 5% differential ratio! This is the purpose of Carry Trade: make money out of interest rates, not price movements on charts.
- If the currency you are buying strengthens and its value increases, you win twice! Both from the 5% differential ratio and the stronger value of the pair in the market
Important: If the differential ratio of a certain pair equals #%, it means that if you wish to sell it (buy the counter currency by selling the base currency), the ratio is inverted (-#%). For example, as the interest rates stand in July 2016, if the differential ratio of NZD/JPY when buying NZ Dollars is 0.2.60%, it would be -2.60% if you decide to open a Sell position for this pair, meaning, buying yens by selling dollars.
Carry trade is a recommended trading method for low-risk currencies, which represent strong markets with stable economies.
How can you choose the right pair?
First, we look for a pair with a relatively high differential ratio. The pair should already be stable for a long period. Uptrend current conditions are preferred, especially if the stronger currency of the two is the one to strengthen. We would want to choose a pair that consists of a currency with a relatively high-interest rate that is expected to rise even more in the near future; and on the other hand, a currency with relatively a very low interest rate (for example, NZD or JPY), which is expected to maintain the same level in the near future.
Remember: Popular pairs for Carry Trade right now are AUD/JPY; AUD/CHF; EUR/AUD EUR/NZD, AUD/CHF, and NZD/USD.
Look at the next example of the NZD/JPY chart:
This is a daily chart (each candle represents a day). You will notice a strong bullish trend bottoming out after the Brexit referendum. We know that the interest on JPY in 2016 was -0.10. The interest rate on the NZD at the same period of time is 2.25%, with a good potential to rise. Meaning, we have a pair with a high differential (buying New Zealand Dollars with a 2.25% interest rate while selling Japanese yen with a -0.1% interest rate. The differential rates add up to 2.35% interest!). Besides, notice the high profits you could have made just on the bullish trend of the pair itself!
Swing trading or benefiting from interest rates is one of the advantages of forex that other financial markets, such as indices or commodities, don´t offer. Buying separate stocks is pretty similar because the dividend replaces the interest rate.
Go to your practice account and let’s practice the subjects we just learned:
- Try to find some situations where two different indicators show opposite signals on the same chart.
- Try to identify Elliott Wave patterns and trade by them.
- Use the Swing Trade method and open positions based on it.
- Trade by using the Divergence Trading strategy (Regular and Hidden). Choose which indicator to work with.
- Look for Breakout points according to what you have learned.
- Open two positions simultaneously (on two different pairs) according to the fundamental Currency Correlation strategy.