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Trading guides, webinars and stories
Trading guides, webinars and stories
Before we talk about forex carry trading, it would be useful to define carry. The cost or income from owning an asset is referred to as the ‘carry’. For example, commodities are often negative carry assets because they may depreciate and they cost money to store. Positive carry assets include financial instruments such as bonds. As you hold them, they pay an income.
Now let’s take a look at carry trading from the perspective of forex trading. Carry trades in forex exist because of a basic mechanism in forex trading. The terms for this mechanism are the rollover or swap or financing fees. The rollover occurs automatically for all forex positions; traders do not specify they want to have a carry trade. While rollover is often the most common name, they all mean the same thing: forex positions either earn income or cost a fee for being held overnight.
When it comes to the forex market, overnight means after 5 pm Eastern Standard Time. This is when the rollover is calculated, and it always occurs then as the overnight rollover (even if the position was opened soon before 5 pm).
The last step in understanding forex carry trading comes in knowing how the rollover is calculated. The rollover is based on a comparison of the interest rates of the two currencies in the forex pair.
As a simple example, imagine the American overnight interest rate is 2.5% and the Canadian overnight interest rate is 1.5%. These rates are determined by the central banks of the country. Entering into a position in the USDCAD forex pair and holding it overnight (past 5 pm) would create a rollover. If this was a long position in USDCAD, then the rollover would be [USD interest rate – CAD interest rate]. Here that would mean 2.5% – 1.5% = 1% of rollover earnings. A sell position in USDCAD would be the inverse, 1.5% – 2.5% = 1% of rollover fees.
This 1% fee or earnings from the rollover is even smaller than it might appear. These interest rates are expressed in per annum terms, meaning 1% interest per year. For this reason, the 1% of rollover is then divided by 365 to change the rate to daily. So far this sounds insignificant. The last key component is that forex trading is typically done with large leverage, up to 50 to 1 in the USA. This means that if you trade have $1000 in your account and 50:1 leverage, you can take a forex position of up to $50,000.
The leverage multiplier matters a lot when it comes to rollovers. It allows traders to have much larger positions, which goes hand in hand with larger rollovers. Another facet that helps carry trading is the ability to choose the forex pair of the trade. In the example above we showed a 1% difference but this rate could be much larger. Though they are not usually together in a forex pair, take the Swiss franc at an interest rate of negative 0.75% and Argentinian peso at 40%. They create a much larger 40.75% interest rate per year, or about 0.11% per day on a position. For a position of $100,000 ($2000 account at 50:1) the rollover would be $111 per day.
There are pitfalls to using this strategy as well. The most important one to consider is that the trade itself could be a loss. Carry trades are more successful in currencies that are stable, but there is always the possibility of danger. When you find a currency with a good enough interest rate to be used in carry trades, there are probably many other traders thinking the same thing.
This is a problem because everyone will want to close their positions if the exchange rate starts moving against the currency that was bought, in favor of the sold currency. As everyone sells the currency, the price gets even worse and there are liquidity concerns.
Carry trading has been noted to cause disruptive issues of this nature, like the appreciation of the Japanese yen around the time of the subprime mortgage bubble. Mid 2007 the exchange rate was 124.176 yen for one USD. By the end of 2008 it had slipped far to 90.612, meaning the yen was much stronger relative to USD. Japanese yen are a typical currency to use in carry trades due to their stability and policy of keeping the value low.
The US economy had issues starting in 2008, due to the subprime bubble. The Federal Reserve had two key reactions to this: credit easing,and lowered interest rates. Credit easing is a process where the Fed buys debt to inject money in the economy. This injection reduces the value of the dollar. Combined with the lower interest rates, this suddenly made carry trades far less attractive.
For these reasons, less carry trades were taken on after the subprime crisis began. Even more significant is that everyone exited their carry trades, meaning they bought yen. This only gave more fuel to the fire by adding an influx of yen buyers, driving up its value further. This was far less than ideal for both the US and Japanese economies at that time. By late 2011 the exchange rate had moved all the way to 75.56, meaning a much stronger yen relative to USD.
Carry trades are an important facet of Forex trading that can strongly influence currencies. Use them carefully and watch out for moments where they might change the game.