This article will describe this long term trading strategy, used mostly by institutional investors, highlighting rewards and risks in a simple way, to make it possible for you to use it as well. With carry trade you can make or lose money even if the price of a currency pair remains static for a long time. It will also help you understand the reasons behind some of the market's moves, especially during volatile and risk-off periods.
► What is carry trade?
Even though it's possible to have carry trades in a variety of financial instruments and investments, the basic premise is the same.
- Positive carry trade occurs when someone borrows an asset with low interest rates to finance the investment in an asset with a higher return. For example, borrowing money at 2%, and then investing the funds in an asset that pays 5%. This is easily done in the Forex market, because currencies are traded in pairs, so a positive carry trade is obtained when a trader buys ("carries") a high interest rate currency (for example, AUD), and sells a low interest rate one, such as JPY.
- Negative carry trade, as expected, is the opposite. This situation happens when the yield of holding an asset isn't sufficient to cover its financing costs. For example, shorting AUD/JPY.
► Rollovers/swaps explained
Trading Forex is very similar to trading futures, with both markets having contracts, rollovers, and settlement dates. The main differences are that contracts in Forex don't have a fixed sized, they're technically settled in just 2 days (compared to several months in futures), and unlike the futures market the rollovers in Forex are automatically done by the broker everyday.
When you go long 100,000 EUR/USD you are in fact, technically, agreeing to receive 100,000 euros from the broker and in exchange delivering the equivalent amount in USD, in two business day. And it would be actual physical exchange of money, from one party to the other.
In order to avoid physical settlement of the contracts, brokers automatically roll over/swap the settlement date to the next delivery day, and this is done repeatedly for as long as the position is open, so the trader isn't even aware that he is trading contracts that have a very short expiration date. Rollovers are done on positions held open at 5pm, New York time (currently 9pm GMT), that's when officially a new day begins in the Forex market.
► So how does carry trade work in Forex?
Because you're holding positions overnight, interest must be debited/credited when the contracts are swapped, depending on the interest rate differential between the two currencies, and whether you're long or short. You always "receive" interest on the currency you own, and "pay" on the currency you sell, and then the differential is debited/credited on the account. If the currency you bought has a higher interest rate than the other one in the pair, that's a positive carry trade.
For example, Australia's benchmark interest rate is currently 3.5%, and in Japan it's 0% (actually 0 to 0.1%), so if you are long AUD/JPY, you receive interest every day at an annualized rate of 3.5% on the Australian dollars you've bought, and pay every day an annualized rate of 0% on the Japanese yen you've sold, so you've a positive carry trade of 3.5% (unleveraged), which will be credited to your account. Using 10:1 leverage on your trade, you'd stand to make a profit of 35%.
If you were short AUD/JPY then the rate differential would obviously be negative 3.5%, which would be debited. This in very simplistic terms, because the whole process is a bit more complex.
► The "real" swap rates
Unfortunately, the final swap rate isn't simply (interest rate A - interest rate B), supply and demand in the interbank spot swaps, as well as rollover costs and mark-up commissions added by the broker, means that you always receive less than the interest rate differential if you have a positive carry trade, and pay more than the interest rate differential if you have a negative carry trade.
Also, some currency pairs will have negative carry trades on both long and short positions, this usually occurs when the two currencies have similar interest rates.
Using our AUD/JPY example, if you were long you'd be credited only about 3.2% (and not 3.5%), while if you were short you'd be debited around 3.8%.
► Using Dukascopy's tools to find potential carry trades
Swap rates are applied to your account not as a direct credit/debit of money, but by adding or subtracting pips to the trade. This is Dukascopy's Regular Swap Rates table:
If you go long AUD/JPY, then 0.75 pips would be deducted from the price at the time of the rollover. So if you had bought at 81.00, the opening price would become 80.9925, and the next day 80.985, then 80.9775. You keep getting a lower entry price, and as a buyer you obviously want to buy as low as possible.
On the other hand, if you go short the same pair, then 0.84 pips would be deducted from the price. So if you had sold at 81.00, the price would become 80.9916, the next day 80.9832, then 80.9748. The entry price is getting lower, but as a seller you always want to sell at higher prices, so that's a negative carry trade.
Positive carry trades are the ones when pips are deducted to long positions (they have a "-" signal and are highlighted by me in blue), as well as when pips are added to short positions (the ones highlighted in red). All the other cases are negative carry trades. Note that these swaps rates can change on a daily basis, this table is valid for October 1, 2012.
Then there's the Dukascopy Forex Calculator, which will also give you the swap rates in monetary terms, you just need to select the currency pair, and change the Rollovers setting to "Regular". Going long 100,000 AUD/JPY gives you a positive interest of 0.75 pips, or US$9.65 per day, while going short gives you a debit of US$10.81.
► When to use carry trades to make a profit
The best potential carry trades are obviously the ones where there is a big interest rate differential between the two currencies, but that alone is not enough. For a trade to be overall profitable, your position should at least maintain its value over time. However, in some cases, if the interest rate differential is very big it may be possible to make money even if the market moves slightly against your position.
This is a monthly chart of USD/MXN, the pair didn't go anywhere once the dot-com recession of the early 2000's ended, remained mostly flat. But because there was a big interest rate differential, shorting this pair was extremely profitable for several years. Notice how the collapse of the financial markets in 2008 caused a major rise in risk aversion, and a sudden spike in this pair.
In short, this is a strategy that works best when there's risk appetite in the market, so riskier currencies (usually the ones with higher interest rates) are in demand, while lower risk currencies (such as the yen) are sold. This allows you to stay in the trade for as long as possible (even though this isn't a purely directional trade, you should always place a stop-loss), while making money off the interest rates. We are currently in a risk-aversion mode, so market conditions are not ideal at the moment.
► Carry trade risks
Due to its popularity among large institutional investors, this can become a very crowded trade. Once risk appetite disappears from the market, riskier currencies quickly become out of favor with investors. What we then have is a panicked run to the exit door to close their positions, this is called "unwinding of the carry trade", causing extreme moves in the market.
What you see here is a perfect carry trade and its consequent unwinding. USD/RUB was trending lower without much volatility for five years, in part do to carry trade. But once the market got into risk-off mode (September 2008), the whole move was reversed in just a few months, because massive short positions were being closed at the same time. You'll need to get out when the circumstances change, you don't want to be the last one closing the trade.
The biggest risk, however, is that the market moves against your position so much that the positive carry cannot compensate for the losses, so don't open positions just because of the interest rate differential, always look at the bigger picture of the pair, study the market conditions and its appetite for risk.