What is the carry trade strategy in Forex and how to use it?

Currencies are tied to their respective economies, which means that the interest rates of each country can greatly affect Forex trading. The main function of central banks is to keep inflation in a healthy level. The most important factor that helps the economy grow is stability. Low, steady and predictable inflation creates a stable environment. In order to tackle high inflation, central banks rise interest rates. Consequently, different countries have different interest rates. Which led traders to develop fx carry trade strategy.

Traders can use the difference between interest rates of different currencies to make a profit by borrowing funds in a currency with a low interest rate and exchanging those funds for a currency with a higher interest rate. This article will look at how carry trading works and what methods traders can use to make the most out of such strategies.

Core features of a carry trade strategy in fx

• Carry trading involves borrowing low-interest currencies to buy high-interest ones and profit from the difference
• Most carry trades involve the Swiss franc (CHF) and the Japanese yen (JPY) due to the low (or even negative) interest rates available in these countries
• Average carry trading returns can range from 2-5% to as much as 50-70% for highly leveraged traders
• Highly leveraged traders can get high returns with mini and micro lots, while traders who do not use margin will benefit most from standard lots
• Any functional trading platform can be useful for carry trading, as it does not require as much technical analysis as other, more complex strategies
• Traders are advised to keep track of the fundamental and pay special attention to the central bank policies that can affect the currencies they wish to carry trade

How does Forex carry trade strategy works?

Carry trade strategy for forex is one of the least complicated Forex strategies available on the market. Central banks issue currencies and are the monetary authorities that govern the interest rates applicable to these currencies. Because economies are constantly undergoing changes, central banks may raise or lower interest rates. The primary reasons for doing so are often to boost economic activity and growth by lower rates, or to curb inflation by higher rates. While advanced economies are unlikely to make drastic shifts overnight, small, incremental changes can still affect the economy and the forex market considerably.

Purpose of carry trading

The core principle behind carry trading is to benefit from the difference in interest rates between two currencies. While the US dollar, the euro, or the pound are not known for high interest rates, currencies, such as the Turkish lira (TRY), Hungarian Forint (HUF) and Brazilian real (BRL).

Using carry trade fx strategy to find favorable opportunities attracts thousands of traders to the market.

Borrowing funds in a low-interest currency and using the borrowed funds to buy a high-interest currency also boosts demand for the latter. The key issue for traders in such scenarios is stability, as highly volatile pairs can render the strategy obsolete – with exchange rate changes eating into any profits derived from interest rate differences.

Carry trade strategies come in two distinct forms – positive and negative. A positive carry trade happens when a trader borrows at a lower interest rate to buy at a higher rate, while a negative carry trade is the inverse of that.

Frequently used currencies in carry trading

POSITIVE CARRY TRADE

Buying (carry currency) / borrowing (funding currency)

AUD/CHF

High interest rate/low interest rate

The choice of currencies for carry trading can be a complicated one. While on the one hand, traders have access to reliable, highly liquid currencies of developed countries, not all of them will have interest rates that can make for profitable carry trading. On the other hand, currencies with high interest rates can be much more volatile than their counterparts and come with exchange rate risks.

Historically, carry trading has been done using the Japanese yen and Swiss franc, which are currencies of highly developed countries with stable financial markets and reliable governance to oversee their monetary policies.

On the other side of carry trades, we will mostly find currencies of developing countries with less liquid financial markets and less transparent policymaking, which involves risk. Some high interest currencies are the Turkish lira, Brazilian real, Hungarian forint and Mexican peso.

The question of stability often prompts traders to take the less risky option, which is the Australian dollar, which has a relatively higher interest than Canadian and US dollars.

Positive Forex carry trade strategy

NEGATIVE CARRY TRADE

Buying (carry currency) / borrowing (funding currency)

GBP/USD

Low interest rate/high interest rate

A positive carry trade happens when a trader borrows a low-interest currency to buy those with high interest rates. While certain currencies may offer higher interest rates than most, they are also far more volatile than most. One such example of a positive carry trade can be observed in the AUD/CHF pair. Let’s assume that the Bank of Australia offers 5% interest, while the Swiss National Bank offers 0.5%.

If the initial position of a trader is worth 10,000 Australian dollars, holding the currency would make the funds eligible for a 4.5% interest income (5% – 0.5%). This would net the trader 450 Australian dollars worth of profit.

While this is a relatively simplified example of a positive carry trade and could involve other costs, the principle mechanics of the trade are largely the same.

Negative carry trading strategy

The inverse of a positive carry trade, a negative carry trade, involves borrowing at a higher interest rate to buy a currency with low interest. The core assumption here is that the currency with a lower interest rate will appreciate in value against the currency with a higher interest rate.

This also causes negative carry trades to have a much tighter interest rate spread than positive carry trades.

For example, suppose the interest rates offered by the Federal Reserve and Bank of England are 3% and 2.5% respectively. Traders would incur a 0.5% loss on the outset, with the assumption that the Bank of England would raise interest rates on the pound and net them a profit.

The key difference between positive and negative carry trades is twofold:

• A positive carry trade results in an initial gain and a potential loss, while a negative carry trade results in an initial loss with a potential gain
• Positive carry trades can have wider interest spreads and are less dependent on the exchange rate than negative carry trades

Pitfalls to avoid when carry trading

The core risks associated with carry trades are the exchange rate and leverage, which can cause traders to miscalculate their trades and lead to losses. The key in making successful carry trades are in identifying less volatile currencies with high interest rates and entering the market at favorable prices, which can mitigate the exchange rate risk mentioned above.

Highly leveraged traders could also need to pay more on the initial amount if the exchange rate goes against their calculations. Traders need to carefully consider such risks to avoid significant losses.

Pros and cons of carry trades in forex

While carry trading sounds like a no-brainer for leveraged traders, there are some limitations to the strategy. Traders need to consider the pros and cons carefully to protect themselves from substantial losses.

Pros

• Carry trading is simple and does not require much technical analysis or expertise
• Interest rate changes are highly publicized market news that are easy to keep track of
• Traders can make substantial gains if they use leverage
• The exchange rate may tilt in favor of traders while they are carry trading, which can boost profits
• Boosts profits for high-interest bonds, as well as the currency in question

Cons

• Higher returns require significant leverage
• Exchange rates of volatile pairs can reduce returns, or lead to losses
• If the value of the low-interest currency increases, the amount traders have to pay back also increases
• The choice of currencies can be somewhat limited

Carry trade Forex strategy example

Let’s assume a trader wants to make a positive carry trade on the AUD/CHF pair and deposits $5,000 into their account. The broker offers 20:1 leverage, so the trader can use their $5,000 to open a $100,000 position. The trader makes a positive carry trade, with AUD at 5% and CHF at 0.5% interest. The outcomes of such a scenario could be:

• The market continues trading sideways, and the trader gets a profit of roughly 4.5%, which is the difference between the interest rates of the two currencies
• The market trends upwards, and any profit generated from the upside is added to the 4.5% interest profit
• The market trends downwards, and the trader could be closed out of the position if the value drops to the initial $100,000

FAQs on forex carry trades

What does carry trade strategy in Forex mean?

A carry trade is a trade that enables traders to borrow low-interest currencies to buy high-interest ones and profit from the difference once the loan is paid off. Traders can use currencies with near-zero interest rates to buy currencies with interest rates above 10% for optimal profit.

Is Forex carry trade strategy risky?

The risks associated with carry trade strategies can be found in volatility. Some currencies with high interest rates are exceedingly volatile, which can cause the pair to shift back and forth and chip away at traders’ profits.

What is the cost of carry strategy in FX?

Carry trading is not an exceptionally costly strategy to implement. However, this does depend on the amount of leverage used by traders. Highly leveraged traders can generate returns as high as 50%, while traders that do not use leverage would need to trade standard lots to obtain substantial returns.