Carry Trade Explained What Is the Carry Trade?

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1 I The Forex Trading Formula Carry Trade Triad Trading Formula - The Introduction Carry Trade Carry Trade Explained What Is the Carry Trade? The carry trade is a trading strategy in which you simultaneously borrow and then sell a currency with a relatively low interest rate, and then use the funds to purchase a different currency yielding a higher interest rate. By doing this, you are able to capture the interest rate carry or rollover. For example, if you were to buy the AUD/JPY pair, you would be selling Japanese Yen and buying Australian Dollars. To sell something you have to possess it, so when you go to sell the Japanese Yen, you first have to borrow it. When you borrow the Japanese Yen you are charged (currently) 0.50% interest on that money. After you sell the Japanese Yen, you take that money and buy Australian Dollars. By holding the Australian Dollars you are paid 6.75% interest on that money. And it s the spread, or interest rate differential, between these two interest rates where you make your money! Here s how it works: When positioning a carry trade you want the interest rate differential to ALWAYS be in your favor. To obtain the interest rate differential, all you have to do is subtract the interest rate of the currency you sold by the interest rate of the currency you bought. In our example: AUD 6.75% - JPY 0.50% = 5.75% interest rate differential This interest rate carry or rollover is all done on an overnight basis, so you are paying the overnight interest rate on the borrowed currency and at the same time earning the overnight rate on the currency being held. In other words, you are either paying out or receiving interest on the position, depending on whether the interest rate differential is for or against you. Trades are done on a trading day basis and so they are technically closed out at the end of each day. If you are holding your position longer than that, however, your broker simply rolls you forward into a new position for the next trading day. Typically this process is Copyright ForexImpact.com 1

2 transparent, but it does mean that you will either pay or receive the interest differential on your position at the end of each day. Criteria for a Successful Carry Trade There are several elements that make up a successful carry trade: There is a minimum interest rate differential for optimal performance (which I will be covering) You must know the right way to build a basket of pairs when trading this method, and As always you must put good money management principles into practice or you could give back all your profits on just one bad trade. There are also different issues that could make your carry trade unwind and become unprofitable that you need to keep an eye on. In the following section, we will be learning how to create, adjust, and exit (if needed) a successful carry trade. Minimum Interest Rate Differential Before we go any farther, the minimum interest rate differential that you want is 3% on the majors and 6% on the exotics (assuming you plan to trade exotics in which case you need to exercise extreme caution). You want a high enough yield so that the flow of capital from the lower yielding interest rate pair will flow to the higher yielding interest rate pair. This will only occur if the investors and traders are rewarded with a high yield. If you do use exotic pairs, you should limit it to pairs with spreads less than 20 pips. (Any larger spreads than this and it eats into your profits.) Inflation Rate Another major issue that you need to take into consideration is the inflation rate of the currencies in your basket. High inflation can counteract the currency appreciation that would normally occur in a high interest bearing currency. Copyright ForexImpact.com 2

3 I consider anything over 4% inflation to be high, though it s possible this number could change over time. You will need to keep up with what is considered high inflation and adjust your stratagy accordingly. NOTE: The Consumer Price Index is a news announcement that monitors and measures inflation. Two Ways To Profit with the Carry Trade One of the oldest rules in finance is: The flow of money will always move towards the higher rate of return. Therefore, the currency with the highest interest rate should attract more money causing it to increase in value. The opposite is also true: The currency with the lowest interest rate should attract the least amount of money, causing its value to drop. With this in mind, it should come as no surprise to you that the majority of money that is made within a carry trade about 75% is from the capital appreciation that occurs due to investors and traders valuing the higher interest bearing currency over the lower interest bearing currency. The other 25% of the profit made in a carry trade is from the interest gained daily due to the interest rate differential. So just like a blue chip stock that both increases in value and pays a healthy quarterly dividend, the carry trade provides two ways for traders to make a profit: 1. Capital appreciation, and 2. Interest rate differential What is a Carry Trade Basket? The carry trade is rarely if ever traded using a single pair. Rather, you should always diversify your efforts by trading a basket or grouping of currency pairs. It s sort of like building your own mini-forex mutual fund! While trading a basket will lower your overall return, the diversification helps reduce overall Copyright ForexImpact.com 3

4 risk and limit massive drawdowns in your account that could occur when trading just a single pair. So how many pairs should you place in your basket? Simple: As many pairs as possible as long as they qualify. And just to review, a qualifying pair is one in which the: 1. Interest rate differential is GREATER THAN 3% for the major pairs and 6% for the exotics 2. Inflation for either currency in the pair is LESS THAN 4%, and The spread when you trade the pair is LESS THAN 20 pips (only an issue when trading exotic pairs) So in the examples below, all the currencies would qualify: Currency Interest Rate Inflation Rate NZD 8.25% 3.50% AUD 6.75% 3.30% GBP 5.50% 2.80% USD 4.25% 2.41% CAD 4.25% 2.40% EUR 4.00% 2.56% CHF 2.75% 2.00% JPY 0.50% 0.40% Currency Pairs Interest Rate Differential NZD/JPY 7.75% AUD/JPY 6.25% GBP/JPY 5.00% USD/JPY 3.75% CAD/JPY 3.75% EUR/JPY 3.50% Copyright ForexImpact.com 4

5 Money Management and the Carry Trade As with any trading system, long-term profit or loss always comes back to money management. When you are setting up your carry trade, you only want to risk a maximum of 15% of your account at any one time. Of course this will be spread over several pairs. You should also limit the overall exposure per pair to no more than 0.05%. The 0.05% per pair rule will make sure that you are not overly invested into one pair (as this would defeat the purpose of the basket entirely). For example: If you have $20,000 in your account and you are risking 15%, then you have $3,000 at risk in your carry trade. If you have 10 pairs in your carry basket with an emergency stop loss placed at 300 pips per pair, then you are risking your $3,000 or 15% of your account (10 pairs * 300 pips). This is the maximum that you would want to trade for this example. This brings us to a second aspect of money management which is the stop loss. This type of trade is a long term trade that is measured in months and even years. Not days and certainly not hours or minutes! Therefore, your stop loss must have enough room in it to allow the market to move. Believe it or not, I know very experienced money managers who don t use a stop at all when trading their carry trade. I personally want a stop loss in the market as it helps me sleep better at night, but for this system it is NOT essential. If you choose to use a stop loss, it should be 250 to 400 pips away from the market (depending on the volatility of the pair you are trading). For the most part, I use a 300 pip stop loss. But just because the carry trade is a long-term play, that doesn t mean that you just set it and forget it. You do need to adjust and monitor the account at least once a week. Whether you are up or down at the close of the week, you will need to adjust your positions to maintain your 15% exposure. If you have made money then you will need to buy additional lots or mini-lots. If you have lost money you will need to sell some lots or mini-lots. Copyright ForexImpact.com 5

6 You also need to monitor the currency pairs that are in your basket for any interest rate or inflation changes. Most if not all of the currencies post well in advance when an interest rate decision will be made. If a rate decision causes one of your pairs to fall out of qualification, then you will need to adjust your positions immediately. Do not wait until the end of the week. Remember that most of the movement you see after an economic news announcement is directly related to how the news might affect the interest rate. In the long term, if the news is good for interest rates then the price of the currency should go up. The opposite is also true in that if the news is bad for interest rates, the price of the currency should go down. The most apparent risk of the carry trade is that the foreign exchange rates will change, and the trader will have to pay back a more expensive currency with less valuable currency. This is why you should have stops in the market and why you MUST monitor your trade weekly. If a pair is disqualified either due to interest rates change or inflation increases, simply exit the position and readjust your overall position so that you are risking only 15% of your account at any one time. If you want to trade this system a little more conservatively, risk only 10% of your account. Why Should You Have a Carry Trade in Your Forex Account? There are several good reasons to have a carry trade in your Forex portfolio, not the least of which is that it just flat out works. The fundamentals backing the carry trade are sound and proven, and they should continue to work into the future. Next, this trade is easy to learn and can be quickly implemented and monitored, so even casual traders can make time for it. With that said, you do need to understand that this is a long term trade and you could see draw downs as large as 50%. But if you trade in a basket and monitor your trades, this risk can be mitigated. Now that you understand how the Carry Trade works and why you need to add it to your trading portfolio, let s look at some sample trades so you can see how it works in the real world Copyright ForexImpact.com 6

7 The Setup The currency pair has an interest rate differential of 3% or greater on the majors and 6% or greater on the exotics. The spread is less than 20 pips. The currencies need to have low to moderate inflation. If the inflation is high the pair does not qualify. Copyright ForexImpact.com 7

8 The Entry We are looking for a pair that has an interest rate differential, spread, and inflation rate that qualify. If this occurs, then we are going to sell the lower interest rate currency and buy the higher interest rate currency. Copyright ForexImpact.com 8

9 The Stop Loss Place the stop loss 300 pips below the entry if you are going long, and 300 pips above if you are going short. In the example below, we placed our stop loss 300 pips below the entry. If your stop loss is hit but the currency pair still qualifies, then re-enter the position the following week. You would do this when you are adjusting your carry basket. Copyright ForexImpact.com 9

10 The Exit You will need to exit your position if the interest rate differential drops below 3% for majors and 6% for exotics. You would also exit if the inflation rate of the currency you bought becomes high. Remember, the carry trade is a long term trade. The example below lasted nearly three years. Copyright ForexImpact.com 10

11 Carry Trade Trading Rules Entry: If the interest rate differential is 3% or greater on the majors and 6% or greater on the exotics, then sell the lower interest rate currency and buy the higher interest rate. The inflation rate of the two currencies must be low to moderate. If either of the two currencies inflation rates are high, do not enter the trade. If the spread is larger than 20 pips for the currency pair you are looking at, then do not use that currency pair. Stop Loss: The stop loss is placed pips below the weekly close, depending on the volatility of the pair. If you want a set standard stop loss, place it at 300 pips. If you are stopped out but the pair remains qualified, you should then re-enter the position when you adjust your basket. Adjustment: At the end of the week you need to adjust your carry basket. You also need to evaluate your carry basket to see what percentage of risk you have in the market. If the account went up you need to buy more lots or mini-lots to bring your account to 15% exposure. If you account went down you need to sell lots or mini-lots to bring your account to 15% exposure. Next you need to adjust your stop loss. Note: I prefer mini-lots because it allows you to adjust your account to a more precise level. Exit: If a currency pair in your carry basket falls out of qualification, then exit the trade where it is and adjust you carry basket with the remaining pairs to 15% exposure of your overall account size. To fall out of qualification the currency pairs interest rate differential has to fall below 3% on majors and 6% on exotics or the inflation rate of one or both of the currencies in a pair has to become high. Copyright ForexImpact.com 11

12 Trading the Carry Trade: Example #1 This is probably the best known carry trade out there: the USD/JPY. The first week that the USD/JPY qualified to be placed in the carry basket has been marked on the chart. This was the week that the US rates changed and a 3% differential was obtained. A 3%+ differential still stands, so the USD/JPY would remain in the carry basket until it no longer qualified. Copyright ForexImpact.com 12

13 Trading the Carry Trade: Example #2 The chart below shows an example of when the GBP/USD first qualified and then later disqualified. When a pair no longer qualifies, exit the trade and re-adjust your basket. Copyright ForexImpact.com 13

14 Trading the Carry Trade: Example #3 The NZD/JPY has been a very profitable pair to have in the carry basket. This is due to the large interest rate differential. Copyright ForexImpact.com 14

15 Final Thoughts on the carry trade No matter your trading style or preferences, everyone should make room in their trading portfolio for the Carry Trade. Not only is this trade simple to learn and easy to execute, it s also based on strong fundamentals so you can be confident that it will return solid profits for years to come. So take a minute or two and STOP looking at the charts. Instead, look at the currencies themselves (and their interest rates in particular) and see if they qualify using the standards I just gave you. If they do, start building your own Carry Trade Basket so you can enjoy the same profit opportunities that the money managers of the world enjoy. Go ahead, give it a shot. I m confident you won t regret it! Copyright ForexImpact.com 15

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