What is carry trade in Forex?
Did you know that the carry trade is one of the oldest forms of trading strategies first developed by elite money managers? As the trade involves buying and selling two different currencies only those who had access to global markets could participate. But, thanks to huge advances in technology accessing global markets is now easier than ever which is why learning the best way to carry trade in Forex should be high on your list.
In this article, you will learn:
- The carry trade definition.
- How Forex carry trade works.
- The risks of carry trades.
- The best ways to carry trade in Forex.
- How you can use a carry trade strategy through a completely risk-free demo trading account.
Carry trade definition
In the simplest terms, the carry trade is where a trader borrows one financial instrument to buy another financial instrument.
Carry trade example
Imagine a scenario where you borrow £5,000 from the bank who charge you a lending fee of 1%. Now let's say you take that £5,000 and purchase a bond which pays you 4% a year. Your profit is 3% (minus commissions, costs, etc). In essence, you have made a profit from the difference in the interest rate.
What is carry trade in Forex?
The carry trade is very popular in the Forex market. It is a situation when a trader borrows, or sells, one currency with a low-interest rate to purchase another currency with a higher interest rate.
The trader is paying a low-interest rate on the borrowed currency while collecting the return on the higher interest rate of the currency purchased. The difference is known as the interest rate differential.
Below is a list of interest rates set by the central bank of each of the following countries:
*As of 3 February 2020
Essentially, the carry trade would involve borrowing money cheaply from a country with a low-interest rate and invest it into the country with a higher interest rate. In an ideal world, and using the interest rate table above, one would borrow money in New Zealand and pay just 1% interest on it and then invest that money in Mexico where they would receive 7.25% interest, resulting in a net profit of 6.25% (7.25% - 1%).
Of course, this is a simplified example and in reality, the interest rate you pay or receive will be different and depend on how large your position is and any other commissions and costs from the bank or broker you are using.
How Forex carry trade works
The Forex market is the ideal place for carry trades as currencies are traded in pairs. For example, when you are buying the EUR/USD exchange rate you are buying the euro while simultaneously selling US dollars. Fortunately, you don't need euros or dollars in your trading account as the broker will take care of any currency conversions behind the scenes to make the trade. You can learn more about Forex trading in 'The Ultimate Guide to Forex Trading for Beginners.'
When trading Forex with a broker all positions are technically closed at the end of each day, even though the market is open 24 hours a day, 5 days a week. The broker will close and reopen your position and then either credit or debit you with the difference in the overnight interest rate of the currency you have sold and the currency you have bought. This is known as 'rolling over' or 'carrying' a position to the next day.
Brokers typically use the term 'Forex swap' to inform traders what the interest rate differential payout or charge would be, as many add on their own costs to it. Forex trading swap fees can be found directly in the MetaTrader trading platform provided by Admiral Markets UK Ltd for free.
To follow the next steps it's best to download your MetaTrader trading platform first. To download your free trading platform, simply click on the banner below:
How to view Forex swaps in MetaTrader
Once you have downloaded the platform open the Market Watch window by selecting View from the top menu and Market Watch. You can also press Ctrl+M on your keyboard. This will open up a list of markets that are available to trade on. Next, simply right-click on the instrument you are interested in and then select Specification which will open up a Description window with the Swap Long and Swap Short values, as shown below:
A screenshot showing the Swap values in the Description box for a specific symbol in the MetaTrader 5 trading platform provided for free by Admiral Markets, taken on 4 February 2020.
You can also view the swap charges on the Admiral Markets Contract Specifications page, as shown in the example below which shows the Forex swap values for long and short positions for EUR/USD:
Screenshot showing the EUR/USD contract specification page on 4 February 2020.
If you opened and closed a trade on a Forex pair within the same day then there is no 'carry' to pay - you will not be credited or debited any interest rate payments overnight. There are two types of carry trades in Forex: positive and negative.
Positive carry trade definition
A positive carry trade involves borrowing a currency with a low-interest rate while buying a currency with a higher interest rate. The trader will then receive interest rate payments based on the interest rate differential between the two currencies and the size of their position.
Negative carry trade definition
A negative carry trade involves borrowing a currency with a high-interest rate while buying a currency with a low-interest rate. The trader will incur a loss on the interest rate differential and have to pay interest for holding the position.
It is also important to note that any gains made in a carry trade may be offset by the depreciation in the price of the market you are buying. Conversely, any losses made in a carry trade may be offset by the appreciation in the price of the market you are buying. Finding a market which will appreciate in value and provide a positive carry is considered ideal and is discussed more in the carry trade strategy section further down this article.
Leverage carry trade example
One of the biggest reasons the Forex market is popular for carry trade strategy trading is the fact you can trade on margin. This means you only need a small deposit to control a large amount. You can learn more about the risks involved in trading on margin in the ' What is Leverage in Forex Trading?' article.
Let's take a look at a generic leverage carry trade example. A trader opens up a trading account and opens a trade for one mini-lot which is the equivalent to 10,000 units of currency. In this example, let's say it was $10,000. To open this trade the trader does not need $10,000 in her account to do so, the broker only requires a certain margin or deposit to be put aside.
Clients categorised as 'retail clients' can access leverage of 1:30 on currency pairs. This means for a trader to open the one mini-lot position which is equivalent to $10,000, they just need $333 to be held as margin to do so. However, if they have chosen to trade a currency pair with a positive carry, they will get paid daily interest on the $10,000, rather than the $333 needed to open the trade.
While this sounds attractive it is also worthwhile remembering that if the trader chooses to trade a currency pair with a negative carry they will have to pay the daily interest on the $10,000. To understand how leverage works when trading, you can open a free demo trading account with Admiral Markets UK Ltd and trade risk-free in a virtual environment to practice your trading skills and test your ideas.
To open your free demo trading account, simply click on the banner below:
Risks of carry trades
There are risks associated when using a carry trade strategy. For example, the country with a low-interest rate has a low-interest rate for a reason. Typically, central banks will keep interest rates low when the economy is struggling to encourage consumers and businesses to borrow, spend and invest to increase economic activity. When the economy starts to grow again, the central bank may start to increase interest rates to stop it from overheating, thereby affecting any carry trade.
The other risks of carry trades include the appreciation or depreciation of the market you are trading. A trader may benefit from a positive carry and receive positive daily interest payments if they went long, or bought a market, at a certain price. However, if they then exited at a lower price, the loss of the investment may exceed the positive daily interest payments, resulting in an overall net loss.
Risk management in carry trade strategy trading is vital. Using stop-loss orders can help protect your capital from adverse market movements. Knowing your risk sizing and how much you could make or lose on a trade is important and can be done easily by using the Admiral Markets Trading Calculator. This calculator also provides the swap long and swap short charges which are essential to know to be able to find a suitable currency pair with a positive carry.
A screenshot showing the Admiral Markets Trading Calculator with random open and close prices inputs, showing swap short, swap long, margin and profit and loss.
In the hypothetical example above, the trading calculator provides swap long, swap short, margin requirements, commission and profit and loss values for the trade details put into the instrument, lot, leverage, open price, close price and buy/sell fields.
Best way to carry trade in Forex
While the thought of travelling around the world to borrow money in low-interest rate countries and then investing it into high-interest rate countries seems exciting, it's not very cost-effective. Also, it's not that easy to open banking and investment accounts in different jurisdictions to your resident country.
The simplest way is to find a good quality broker that offers competitive trading fees for buying and selling currencies with low swap fees (overnight funding charges), thereby increasing your chances of finding a market with a positive carry.
For example, let's take a look at the Admiral Markets Trading Calculator for EUR/CAD:
A screenshot of EUR/CAD in the Admiral Markets Trading Calculator on 5 February 2020.
At the time of writing, trading EUR/CAD to the short side would provide a positive swap value if the trade was held overnight. The trader would receive 2.07 EUR if trading a one standard lot position.
However, the trader also needs to think about the appreciation or depreciation of the EUR/CAD exchange rate. The positive carry on EUR/CAD will only be achieved when trading short. This is because the trader will be selling the euro which has a low-interest rate (0% at the time of writing), while simultaneously buying the Canadian dollar which has a higher interest rate (1.75% at the time of writing).
If the trader went long on EUR/CAD they would be paying 11.87 EUR each night for the position resulting in a negative carry. But if the exchange rate appreciated, the profit from the trade may offset any accumulated overnight swap fees. However please notice, that past performance is not necessarily an indication of future performance.
Therefore, the best way to carry trade in Forex is to also have a trading strategy which helps you to identify currency pairs which will trend and appreciate or depreciate over time. You can learn more about trading strategies in the ' Forex Trading Strategies That Work' article.
You can also use the automated analytical tools, pattern recognition scanners and the actionable technical analysis from Trading Central's human analysts and intuitive algorithms provided by Admiral Markets for FREE, to help identify market trends. To start your download, simply click on the banner below:
Carry trade pros and cons
One of the pros of the carry trade is that a trader could potentially earn profit from the interest rate differential on positions held overnight, on top of any appreciation of the market being traded.
For Forex traders, the major advantage is the use of leverage where you can benefit from the interest rate differential on the full value of your position rather than just the money held in margin to open the trade. However, this is also a con of the carry trade in Forex as using leverage can also mean bigger losses.
Another con of the carry trade is that currencies can be quite volatile and interest rates do change over time. This means the trader needs to be kept up to date with new central bank actions, as well as perform analysis on finding markets that offer a positive carry but that will also provide a positive return on their investment. As always, risk management is key to managing your capital.
Why carry trade Forex with Admiral Markets?
- Use leverage of up to 1:500 for professional categorised clients and up to 1:30 for retail categorised clients. This means you could control a large position with a small deposit. You can learn more about the benefits and risks in the 'What is Leverage in Forex Trading?' article.
- Trade with a well-established, highly regulated company including regulation from the UK Financial Conduct Authority, the Australian Securities and Investments Commission, the Cyprus Securities and Exchange Commission and the Estonian Financial Supervision Authority.
- Access the fastest and most popular trading platforms from MetaTrader for PC, Mac, Android and iOS operating systems.
- Benefit from a negative balance protection policy for peace of mind.
If you're feeling inspired to start trading, or this article has provided some extra insight to your existing trading knowledge, you may be pleased to know that Admiral Markets provides the ability to trade with Forex and CFDs on up to 80+ currencies, with the latest market updates and technical analysis provided for FREE!
To open your trading account, simply click on the banner below:
About Admiral Markets
Admiral Markets is a multi-award winning, globally regulated Forex and CFD broker, offering trading on over 8,000 financial instruments via the world's most popular trading platforms: MetaTrader 4 and MetaTrader 5. Start trading today!
This material does not contain and should not be construed as containing investment advice, investment recommendations, an offer of or recommendation for any transactions in financial instruments. Please note that such trading analysis is not a reliable indicator for any current or future performance, as circumstances may change over time. Before making any investment decisions, you should seek advice from independent financial advisors to ensure you understand the risks.