How to Carry Out Carry Trade in Forex Trading?

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I. The Basic Concept of Carry Trade

Carry trade is a trading method that is now one of the most popular in the global forex market. You often hear about it in forex reports, and some believe the Japanese yen is one of the culprits for the prevalence of this type of trade.

Carry trade involves borrowing a low-interest currency and then using the borrowed funds to buy a high-interest currency. Of course, leverage is used in carry trade to greatly increase the level of return. The borrowed funds can also be other low-interest financial instruments, and the purchased assets are not necessarily currency.

Broadly speaking, carry trade is about capturing the interest differential between two assets. Since the interest on currency is the basis for the interest on other financial assets, carry trade is generally based on the interest differential between currencies of different countries.

Let’s illustrate carry trade with an example.

First, you go to the bank and borrow $10,000, assuming they charge 1% interest per year.

Next, you use the borrowed currency to buy a $10,000 bond with an annual interest of 5%. So, what is your profit? Your profit rate is 4% per year. It’s the interest differential between the two assets.

Now you might think: “This doesn’t sound as exciting as volatile trading or day trading! It seems like you can make a lot of money without thinking.” Although it sounds very simple and old-fashioned, it is neither simple nor boring. If you can use higher leverage and get a daily interest payment, watching your account grow every day is a very happy thing!

II. The Operation of Carry Trade in the Forex Market

In the forex market, currencies are traded in pairs, as when you buy USD/CHF, you are buying US dollars while selling Swiss francs. Just like the example above, the currency you sell needs to pay interest, and the currency you buy, you can receive interest. The special thing about carry trade in the spot forex market is that the payment of interest is based on the position on each trading day.

Technically, all positions are settled at the end of the market. If you hold a position overnight, you may not see this happen. The broker ends your position and then helps you open a position again, then they pay you or charge you overnight interest, which is the interest differential between the two currencies.

This is the cost of holding a position overnight, also known as the rollover fee. Of course, some brokers will also charge an additional holding fee, regardless of whether you hold a low-interest or high-interest currency.

Because the forex market can use very high leverage ratios, carry trade is very popular in the forex market. Forex trading is entirely based on margin, which means you only need to provide a small amount of capital to carry out carry trade. Many brokers only require you to provide 1%~2% of the capital needed for the position.

Let’s look at an example to experience the power of leverage in interest differential trading. Suppose we have a friend who is just starting to trade forex, and he has $10,000. At the beginning, he wanted to save this money.

He went to the bank to ask, and the bank staff told him that they could pay 1% interest per year, which meant he could get $10,100 at the end of the year, but he felt that the interest was too little. So he looked for other investment channels.

He happened to know some people in the forex trading field. After a detailed understanding, he wanted to engage in forex trading. But before trading, for the sake of prudence, he followed our advice, learned basic trading knowledge, and opened a demo account for trading practice.

After two months of hard work, he had mastered the basic trading skills well. Then he opened a real trading account and deposited his initial capital of $10,000.

Our friend first carried out a relatively safe carry trade, he found a currency pair that could bring a 5% interest differential, and he decided to buy $100,000 worth of this currency pair.

Since his broker only requires a 1% margin, which is a 100:1 leverage they offer, he only needs $1,000 to control a currency pair worth $10,000, and he can receive 5% interest on the $10,000 worth of assets every year.

This is higher than the return he would get if he deposited the money in the bank. What would happen if this friend did nothing during this year?

(1) The currency pair lost its original value. The currency pair held by this friend lost most of its original value. If these losses cause the account funds to fall below the required margin level, these positions will be forcibly closed.

(2) At the end of the year, the currency pair maintained its original value. In this case, the friend gained that 5% interest differential income. This means that by the end of the year, his total capital increased by $5,000, almost a 50% growth rate.

(3) The currency pair appreciated. If the currency pair held by the friend soared like a rocket, then what he harvested at the end of the year was not only the $5,000 interest differential but also the price differential income. It can be said to be a double harvest! With 100:1 leverage, he achieved a 50% annual return, turning $10,000 into $15,000.

If you buy USD/JPY and hold it for a year, then you will get a positive interest differential, which is 5%. Of course, if you sell USD/JPY, then you will have to pay a 5% interest differential at the end of the year. If you sell USD/JPY and hold it for a year, then you will get a -5% interest differential. This is the operation process of interest differential trading.

III. The Risks of Interest Differential Trading

If you are a professional trader, then I believe you already know the first question you need to ask before any trade: “What kind of risk am I taking?” A wise person looks at the risk first, not the profit.

Before entering any trade, you must assess the maximum risk you face and prepare for the worst. And decide whether to participate in such a trade according to your own risk management rules.

In the previous example, the biggest risk faced by the friend would be $9,000, and his position would be automatically closed when he lost $9,000. This doesn’t sound too good. Remember: this is the worst case, our friend is a novice, so he can’t understand all the value of stop loss.

When conducting an interest differential trade, you must pay attention to limiting risk like a price differential trader. For example, if our friend decides to limit the risk to $1,000, then he can set the stop loss to close the position when the account loses $1,000.

IV. The Criteria for Interest Differential Trading

Finding a pair of currencies suitable for interest differential trading is very easy, look at the following two aspects:

(1) Look for a currency pair with a large interest differential.

(2) Look for a currency pair that is in a clear trend, so that you can not only earn interest but also prevent the currency pair from depreciating, and you can earn the price differential.

Let’s look at a real example of interest differential trading. The Bank of Japan has always pursued a zero-interest-rate policy, and after a few rate hikes, the pace of rate hikes has been very slow.

From 2003 to 2006, the Australian dollar rose because it caught the tailwind of China’s economic development. You can see the Australian dollar rising against the yen, which just meets the second requirement of interest differential trading.

The first requirement is that the interest differential between the two currencies that make up the currency pair is large enough, and AUD/JPY meets both of these requirements. Of course, anything can change, interest rates and interest differentials will change. So interest differential trading is also a form of trading under specific conditions.

V. Conclusion

As you can see from interest differential trading, there are many ways to make money, of course, the interest differential is not as easy to pocket as it seems, any means of making money comes with risks.

If you catch the right currency pair at the right time, then you can get a decent return. If you can use interest differential trading flexibly and appropriately, then your arsenal undoubtedly has one more trump card. I hope you can combine price differential trading with interest differential trading, just as you combine technical analysis with fundamental analysis. It’s quite exciting!

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