Swing traders and position traders in particular love carry trading. The strategy involves looking at interest rates among different countries and taking advantage of their differentials. This article will look at how the carry trade strategy works and how central banks are involved in all this.
How interest rates work
To find out how the carry trade strategy works, let’s learn how interest rates are set and what goes in the mind of central bankers. For starters, central banks have two main important roles. First, they are tasked with ensuring that there is a low unemployment rate in an economy. Second, they are mandated to ensure that consumer prices remain steady.
Central banks are given unique tools to support the economy. The most important tool is that they are mandated to set interest rates. They are also given the right of printing money to deal with emerging issues.
Therefore, in a period of high economic strains, the central bank can easily slash interest rates. Doing this will encourage savers to withdraw their funds and invest or spend. Additionally, lowering interest rates will make it relatively cheaper for people to borrow money. After borrowing, they will invest or boost their spending, which will increase business activity in an economy.
In dire economic periods such as during the Global Financial Crisis (GFC) or the Covid-19 pandemic, central banks have other tools. A common one is known as quantitative easing (QE). This measure involves printing money and then buying assets like mortgage-backed securities (MBS) and treasury bonds. By doing this, the central bank is able to improve the liquidity in the market and sustain the recovery.
At the same time, central banks are not fond of extremely low-interest rates. Besides, these low rates tend to hurt the profit margins of banks. They could also lead to bubbles in an economy. Therefore, when the market conditions improve, central banks tend to start hiking interest rates gradually.
How a carry trade works
A carry trade works because countries have different interest rate regimes. For example, at the time of writing, the United States has a benchmark interest rate of between 0% and 0.25%. In the same period, a country like South Africa has its benchmark interest rate of about 12%. Countries like Switzerland and Japan have had negative rates for years.
A carry trade works in a relatively easy way. For example, assume that a money market account in company A yields 5% while you can borrow funds at a 3% interest rate. In this case, you can borrow funds at 3% and then invest them in a money market fund account that yields 5%. As a result, you will make a return of 2%, which is the spread between what you borrow and your returns.
A carry trade works in a similar way. For example, assume that a country like Switzerland has an interest rate of -0.75%, and the US has a rate of about 0.25%. In this case, you could borrow funds at a substantially low-interest rate of -0.75% and then invest in the US, where you will earn 0.25%. As a result, your profit in such a trade will be 1%. This is how a carry trade, in theory, works.
There are several components of carry trade in forex trading. First, there is the carry currency, which typically pays a higher interest rate in a transaction. In the example above, the carry currency is the US dollar since it is paying a higher interest rate. Second, there is the funding currency, which is the one being borrowed.
Why a carry trade strategy works
In forex, you can simply buy a currency pair, which you expect to keep rising or sell the pair you expect to decline. For example, if the EURUSD is trading at 1.1100, you could buy it and benefit as it rises to 1.1200. In doing so, you have just bought the euro while shorting the US dollar. Meanwhile, you could sell the pair, in which you will be buying the US dollar and shorting the euro.
Therefore, in the USDCHF example above, in carry trade, you will simply short the funding currency (CHF) and buy the carry currency.
A carry trade works because brokers tend to pay interest for all trades you hold overnight. Therefore, your goal is to look for a currency that has a positive swap. Examples of these, at the time of writing, are going long the USDCHF and USDJPY while shorting the EURUSD.
How to use the carry trade well
There are several steps you need to take when using a carry trade strategy. First, you need to understand the overall interest rates between countries. In this case, you should do your study to see what interest different central banks are paying. A simple Google search or a look at the economic calendar will show you clear answers to this situation.
Second, in most cases, the swap interest you get will be relatively small. Therefore, you should combine a carry trade strategy with other approaches like technical analysis.
In technical analysis, you will use indicators like the Donchian Channel and Klinger Oscillator to determine the direction of a currency pair.
On the other hand, you will use patterns like triangles, cup and handle, and head and shoulders to determine the future price.
Finally, you should always protect your trades with a stop-loss or a trailing stop-loss. Doing this will help you stay safe when the trade goes against you.
Summary
A carry trade is a strategy that often looks confusing to many people, yet it is one of the easiest to understand. In this article, we have looked at how it works and some of the top strategies to use.
