We’ve already explored the idea of carry trades in the previous lesson. The concept is simple enough: traders use this technique in an attempt to profit from the interest rate differential – which you may now know is called ‘rollover.’

This lesson will explain FX carry trades further through examples. We’ll also explore popular carry trade strategies and how you can try to incorporate them into your trading plan.

What’s a currency carry trade and how does it work?

A carry trade involves borrowing a currency in a country that has a low interest rate (low yield) to fund the purchase of a currency in a country that has a high interest rate (high yield).

The idea behind it is to hold such positions overnight in the hope that an interest payment will be made to you based on the ’positive carry’ of the trade.

The lower yielding currency is referred to as the ’funding currency’ while the currency with the higher yield is referred to as the ’target currency’.

As you would’ve learned in the previous lesson, this is facilitated by rollover rates.

As a reminder, this is when your broker either debits or credits your account based on the direction of the open trade (long or short), and whether the interest rate differential is positive or negative.

Since interest is quoted as an annual figure, these adjustments will be the daily adjusted rate for each day you leave your positions open ‘overnight.’

Remember, interest rates are set by a country’s central bank in accordance with the mandate of its local monetary policy. This will differ from country to country.

In a carry trade, your aim is to earn interest on a currency you’re ‘long’ on, which would be the one with the higher interest rate.

There are two main components to FX carry trades:

1. Changes in interest rates

The main component of carry trades is centered around the interest rate differential between the two traded currencies.

For example, if the Australian dollar has an annual interest rate of 4% and the Japanese yen’s rate is set at 0%, you could look to buy (long) AUD/JPY to take advantage of the 4% net interest rate differential.

Even if the exchange rate between the two currencies remains unchanged, you’ll likely profit from the overnight interest payment. However, central banks tend to alter interest rates over time, and this poses a potential risk to this strategy. In short, there’s potential for the interest rate differentials to go against you on the same trade you previously benefitted from.

2. Exchange rate appreciation/depreciation

The other component of the carry trade strategy focuses on the exchange rate of the two currencies in the pair you’re trading.

If you’re long on a pair, you’re hoping for the target currency (the base currency) to appreciate. When this happens your payoff would include the daily interest payment and any unrealized profit from the currency.

However, the profit you might make, as a result of the target currency appreciating, will only be realized when you close the trade.

It’s possible to lose money when the target currency depreciates against the funding currency in that the capital depreciation may be larger and thus impact any positive interest payments.

The risks involved with carry trades

The financial markets can be volatile. So regardless of how prepared you might be, you still run the risk of losing money – even with a strategy in place.

Currency carry trades, like most trading strategies, also have a degree of risk. When you use this strategy, you may also want to consider adopting appropriate risk management measures as well.

Potential risks involved with the carry trade include:

• Exchange rate risk: should the target currency weaken against the funding currency, you could see the trade move against you but still receive the daily interest. Emerging economies, for example, can present high interest rates relative to developed economies. However, they could also present higher exchange rate risk given that their currencies tend to be more volatile
• Interest rate risk: if the target currency’s interest rate decreases, and the funding currency’s increases, the positive net interest rate is likely to reduce and thus affect the position’s profitability, potentially leading to a loss

An example approach to the carry trade strategy

Filtering FX carry trades in the direction of a trend is one of the strategies experienced traders tend to use. This is because carry trades are normally held over the long term, making them useful for analyzing markets that exhibit strong trends.

One way to do this is to analyze a market’s chart data to try and find an uptrend. This can be seen after the higher highs and higher low in the chart below.

The figure depicts higher highs and a higher lows whereby a break of the horizontal line (drawn at the first higher high) suggests an uptrend. As you can see from the chart, the market continued to move upwards as anticipated.

Note, this won’t always be the case and the market could reverse instead.

Thereafter, it might be helpful to use of multiple time frame analysis and indicators to spot possible entry points to open a long trade. The idea behind this approach is to buy into the market when it shows patterns that suggest that an uptrend is imminent.

Remember, speculative trading carries the risk that the market won’t move as you anticipate it will. Consider using appropriate risk-management tools and techniques to try and minimize your losses.