Carry Trading Forex Strategy
Carry trading with forex represents an interesting strategy for day traders. This article will provide a definition of carry trading, explain trading costs, momentum and timing – and highlight some of the pitfalls and issues that might impact performance.
Key Points:
- Carry trading as it relates to forex involves going long a high-yield currency against a low-yield currency
- Currency-related carry trading execution primarily relies on correctly timing interest rate cycles and having the backdrop of a low volatility, “risk-on” environment
- Common pitfalls include indiscriminately chasing spread, failing to keep up on central bank monetary policies, using too much leverage, and lack of broader-level portfolio diversification
The Basics of Carry Trading
The entire basis of capitalist economic systems comes in the fundamental form of the borrower/lender relationship. It is the spread between borrowing and lending activity that forms the basis by which economic activity is transmitted and how financial markets are priced.
When you invest your money, you are fundamentally chasing a spread. If there was no future return on your money – that is, no spread – then there would be no point to trading or investing in the first place.
Definition
In financial markets parlance, this is typically referred to as “carry.” Carry can be loosely defined as the excess return over cash and can come in various forms:
- credit – e.g., a bond or loan yielding X% over cash
- duration – compensation for financial assets of longer maturities
- volatility – markets tend to take high volatility or uncertainty into account by pricing financial assets lower
- equity (stocks) – assets subordinate to other claims in a company’s financial structure and effectively of infinite duration
- currency-related – borrowing in one currency and using it to buy another currency or financial assets of higher yield
Forex Carry Trading
Carry is one of the most foundational concepts in trading and investing and forex is no exception. Below I will provide examples of how the carry trade is structured with respect to trading currencies:
Forex carry trading broadly means borrowing in a cheap currency, such as the Japanese yen (JPY) or Swiss franc (CHF) and investing in either a higher-yielding currency – e.g., Mexican peso (MXN), Turkish lira (TRY) – or another financial asset.
What currencies are “high yield” and which are “low yield” is relative and dependent on interest rates. Central banks of certain countries or jurisdictions raise or lower short-term interest rates to ensure price stability and/or employment levels depending on their statutory mandate.
Among major currency pairs, AUD/JPY and AUD/CHF have been the more popular carry trade options with AUD being the “high yield” currency and JPY and CHF being “low yield” currencies.
If one were to be long the AUD/JPY, for example, interest would be earned daily. If one were short the pair, interest would be paid daily.
Forex day trading broker OANDA provides a free tool to calculate financing charges on various currencies, where interest earned is a function of the currency pair traded, the number of units purchased, and the amount of time in which it’s held.
Among the major seven currencies (eight if you include the New Zealand dollar (NZD)), the upper-bound overnight rates for each are as follows (also sometimes called benchmark or cash rates):
- NZD – 1.75%
- AUD – 1.50%
- USD – 1.50%
- CAD – 1.00%
- GBP – 0.50%
- EUR – 0.00%
- JPY – minus-0.10%
- CHF – minus-0.75%
Of course, the actual rates offered by any individual broker can materially differ from the spread obtained on trades as implied above. For example, while the above rate might suggest the annual carry from an AUD/CHF trade is 2.25% (1.50% – -0.75%), the actual spread offered by a broker such as Oanda is currently just 1.05%.
In today’s world of low interest rates, carry trades don’t provide the type of return among major currency pairs as they did previously. For that reason, many looking at carry trading strategies will have to go out over the risk curve and borrow in a cheap major currency in order to buy a higher-yielding emerging market (EM) currency in order to earn a yield beyond that of higher-duration US Treasury bonds (considered safe yield). EM currencies are inherently more volatile and subject to risk given they underlie jurisdictions that may be exposed to a less robust rule of law, poor institutions, political instability or corruption, low levels of investment and innovation, lack of private property laws, and/or undeveloped debt and capital markets.
On carry trades, if you are long the higher-yielding currency relative to the lower-yielding currency, interest is accumulated daily. Forex is a 24/5 market, so to compensate, interest is accrued three times the normal amount on Wednesdays.
If you were to buy a standard lot of AUD/CHF (100,000 units of the base currency), the daily interest accumulation would come to the 2.75% spread (assuming it was offered) divided by 365 (the number of days in a year) multiplied by the notional amount, or about USD$7.53 per day (if you bought a standard lot designated in US dollars).
For those short the AUD/CHF, interest is paid daily, just as someone shorting a stock would pay the dividend, if applicable.
Keys to Carry Trading
Follow the actions of central banks
Carry trades develop based on central banks adjusting interest rates, normally the front-end, “overnight” lending rate. The rest of the curve is generally set by the market (one exception is Japan, which also pegs its 10-year yield to keep its curve sloped upward to help banks lend profitably).
When one country tightens its monetary policy (i.e., raises interest rates and/or contracts its money supply) while another is easing (i.e., lowering interest rate and/or expands its money supply) or holding steady, this provides the opportunity not only for carry – assuming the country tightening its monetary policy has a higher-yielding currency to begin with – but for capital appreciation as well.
The idea of going long currencies before they tighten monetary policy and short those that are easing is, of course, a strategy that exists outside of the carry trade concept.
Identify the right environment
Carry trades became heavily unwound during the 2008 financial crisis as liquidity dried up and investors shunned risk-taking. Carry trades are ideal when markets are relatively placid and investors display an appetite for risk.
The Japanese yen and Swiss franc are often referred to as “safe havens” similar to gold (they generally have +20%-40% correlation with the precious metal). But this is only partially true. The yen and franc generally appreciate in value because the leveraged carry trades commonly funded by these currencies become unwound, not because of demand for these currencies themselves.
Carry trades are attractive to investors for much of the same reasons dividend stocks and coupon-paying bonds are. Namely, the market doesn’t have to move for you to make money. Thus, calm, low-volatility environments are generally prime for carry trade opportunities.
Pitfalls in Carry Trades
Carry trades have to be approached carefully and correlate with risk assets such as stocks and high-yield bonds more broadly.
Though AUD/CHF has fulfilled the definition of a carry trade over the past five years, it’s one that has lost money due to capital depreciation. The primary reason has been due to a down-cycle in commodities, as Australia, a resource-rich nation, is a net exporter of coal, natural gas, and uranium.
Global commodities have fallen in price since mid-2014, though have begun to rebound since their early-2016 bottom.
This has trickled into the AUD’s valuation as the Reserve Bank of Australia has cut interest rates to counteract the downswing in growth and inflation:
When central banks cut interest rates and yields decline, investors are likely to move their capital elsewhere to seek out more profitable trading opportunities. When this selling is exacerbated through the unwinding of leveraged positions, years’ worth of gains can be reversed quickly.
Indiscriminately going long a higher-yielding currency against a lower-yielding currency can land oneself in trouble. The more important focus is to determine how rates are likely to change in the future, which is a function of future growth and inflation prospects. Higher growth and inflation are associated with greater likelihood of rate hikes.
Even if you’re in a carry trade with a large spread to it – e.g., long TRY/JPY – if it’s believed that the central bank of Turkey is likely to ease relative to the Bank of Japan – both diminished carry (from a closing spread) and capital depreciation could impair the profitability of this trade.
On top of that, given currency traders often use leverage, even a relatively modest 10% dip in a currency pair combined with 10:1 leverage on a trade will wipe out one’s entire amount of capital committed to that trade. Properly managing risk is vital.
Conclusion
Like any strategy, carry trades must be employed prudently. While technicals, such as support and resistance levels, can be useful in finding entry points, carry trades should not be committed to without an understanding of where central banks are in their monetary regimes and what their next policy moves are likely to be.
Carry trades also tend to be long and directional. Interest rate policies mirror credit cycles. And business cycles typically last 5-10 years. Therefore, this is not a strategy that one would execute as part of a short-term trading orientation, as interest rate adjustments typically occur only once every few months (or years).
Limiting risk should also be accomplished via two main conduits: (1) using only small amounts of leverage (or possibly none at all) and (2) portfolio diversification.
For US-based traders, the Commodity Futures Trading Commission (CFTC) limits leverage available to retail forex traders to 50:1 on major currency pairs and 20:1 for non-major currency pairs.
However, most traders should not use anywhere near these amounts. At 50:1 leverage, a 2% move in the wrong direction will wipe out your entire capital base allocated to a particular trade. If you’re doing carry trading, an intrinsically long-term strategy, you need to allow at least 2% wiggle room for the trade to develop.
Most traders shouldn’t use above 5:1 leverage. Novices should start by using paper accounts and then by avoiding leverage once they begin trading live with real money and determine that they can prove to themselves that they can be profitable over a statistically meaningfully period of time (usually one or more years). Carry trading or trading in general is not a get-rich-quick scheme.
Regarding diversification, this isn’t strictly limited to being in various currency-related carry trades, but through diversification into other asset classes as well, including stocks, bonds, and real assets, such as gold or commodities.