Carry Trading is a time-tested strategy that has been used by large institutions for decades. In this Wiki, we will take a look at what Carry trading is and how you can apply this to your own trading efforts.
This Wiki is part of our Fundamental and Sentiment Trading Strategies Wiki. Be sure to check that out HERE.
Carry Trading
There are other reasons to trade a longer term approach and one of them is for the carry interest that you will receive for holding a certain currency pair in a certain direction.
Carry trading is a very interesting proposition because it gives two incomes from one position in the market. The first is the interest paid to you for holding the position and the second is the capital appreciation you get when the market moves in your favour.
If you buy a currency of a country with a high interest rate against a currency from a country with a low interest rate then you will effectively earn the difference between the interest rates from each country. The opposite is true if you sell a higher interest currency against a low yielding currency then you will have to pay the difference each day at rollover.
To simplify this further, imagine that you took a loan from a bank that charges you an interest rate of 2% and then deposited that money into a bank that will pay you a higher interest rate of 5%. The difference is 3% and that is what you can keep as profit in this example.
Another great thing about carry trading is that lots of other traders have the same idea. If you can get in at the right time it can become a low risk trade. Other traders and institutions will want to get in and as a result drive price in your favour with each new trader jumping in on carry trade positions.
Carry trades should be approached over a period of months and it is also worth splitting your position into 3-5 pieces and planning your entries based on where the price may go over those coming weeks or months. Splitting positions will take the pressure off trying to pinpoint an entry in such a long term position.
Currency prices can be volatile so instead of viewing these price swings with fear you need to train your brain to view them as exciting opportunities. So you can get in at the market, receive some interest, and also plan where you will get in again if the price moves in your favour or against you in the short term.
Exiting the carry trade can be the trickiest part because we are not sure when the move will end. The reality is that carry trades can literally play out over years until something major shifts in the underlying fundamentals and causes a sharp unwind of those positions. Traders hate pain and losses so anything they consider to be a concern they will react to. However, these episodes can also be viewed as an opportunity because traders almost always overreact to good news and bad news alike.
When you see the price hit all-time highs be cautious and when you see prices plummeting despite nothing really changing fundamentally you should be figuring out how to take advantage of this opportunity and get in at a better price.
Generally speaking, splitting your trade over the course of a quarter or even a year can be a good way to time your entries and exits. There is nothing wrong with planning your year around a single trade and waiting patiently for prices to give you an opportunity to build your position. This is strictly position trading and is almost impossible to conduct if you are also day trading at the same time. The day-to-day noise going on in the market might just be too much of a distraction.
If you are a day trader and do want to carry trade also then simply do it on a separate account from the one that you are day trading in and that you do not even open during the day.
You can see the current interest rates that each central bank currently offers by using the internet resources that have already been provided or doing a quick internet search.
Let’s take a look at how the price can move in a carry trade and how you can plan your positions to take advantage of these moves.
We are going to take a look at one of the most famous carry trades in recent years in that of the GBPJPY pair. This carry trade lasted roughly from the beginning of 2000 all the way through to the global financial crisis that kicked off in mid-2007. If that crisis hadn’t happened the trade would have continued on and on until the interest rate differential changed.
You can see on the chart above that we have marked with red vertical lines where the trade started and finished on the monthly chart as it continued to climb higher year after year.
At the time the UK had interest rates between 3.5% and 5.75% during this time period while in Japan the interest rates were between 0% and 0.50% during the same period of time. This meant that no matter what happened investors would gain at least a positive swap of at least 3% and sometimes as much as 5.75% per year by holding this pair long.
Carry traders know that many other traders and investment funds love this kind of trade and the very fact that this type of trade attracts more buying than selling they know that there is an extremely high probability of the price moving higher over the long run too which means their trade goes up in value on top of the really nice interest rate swap.
The rates were so low in Japan because they had been going through at least a decade or more of crippling deflation while the UK had a vibrant economy with positive prospects. This set the stage for this popular trade to buy and hold the GBPJPY which rallied over 9,000 pips in 7 years as more and more traders and investment funds piled into the trade to seek a nice positive swap and the capital appreciation from the price going up.
There were of course large pullbacks along the way but as long as the central bank divergence held then the trade would always come back until the financial crisis hit which changed the overall big picture for the two currencies.
One of the cardinal rules with a carry trade is that you absolutely do not use leverage because if there is a large pullback you could very easily wipe out your trading account on a trade that was still good.
Related Wikis
Readers of Carry Trading also viewed: