*What is a Carry Trade, why they exist and how to profit from them?*
Welcome back to the blog! I hope you all had a great extended weekend and enjoyed the amazing weather that we had in the UK. In this blog post I am going to explain to you a type of trade the can become profitable even if the value of the instrument decreases or remains stagnant for a number of days/weeks and even months.
The Carry Trade – Borrowing at a low interest rate and investing in an asset that generates a higher rate of return. The positive differential is then kept as profit.
This is the basic generalised definition for a carry trade but I am going to show you, in detail, how it specifically relates to trading the FX markets. By the end of this blog post you will be able to understand the mechanics behind a successful carry trade and also possess the ability to find the best potential carry trades.
Carry trades in the FX markets exist because of the interest rates that derive from the central banks of the currencies you are trading. The interest rate differential, whether that is positive or negative, decides the carry profile of the trade and whether you will pay to hold your positions or get paid to hold your positions. The latter being the preferred option!
- Positive Carry = A trader gets paid to hold a trade position in addition to capital appreciation (P&L).
- Negative Carry =A trader must pay to hold a trade position in addition to the capital appreciation (P&L).
FX Currency Carry Profiles.
The carry profile of an FX currency pair is usually made up of two things; the cost of borrowing and the interest rate differential of the currencies involved.
Borrowing costs are the costs associated with borrowing a certain amount of a currency from your broker/liquidity provider. Remember, when you short an FX currency pair you are selling one currency and buying another. For example, if I short $2mm of EURUSD futures contracts I am selling $2mm of Euro’s to buy the same value worth of US dollars. However, I may not have any Euro’s to sell (most likely) so I must borrow them first and this is when you will be charged a small fee to do so.
I have previously explained the mechanics behind a short trade in a different blog post which you can find by clicking on the link below.
Borrowing costs are usually charged as a value of points per standard lots traded so it increases inline with position sizes which is exactly how the interest rate differential is charged.
The Interest rate differential of an FX currency pair is determined by the central bank base rates of the currencies involved. When trading an FX currency pair you will pay the interest rate on the currency you are selling and you receive the interest rate on the currency you are buying.
For example, if i go long $2mm of EURUSD futures contracts then I am buying Euro’s and selling US dollars. I therefore receive the interest rate payments on the Euro’s which is based on the European Central Bank (ECB) rate and I must pay the interest rate payments on the US dollars that I am selling (set by the US Federal Reserve).
Let’s assume the Euro has a base rate of 0.20% and the US dollar has a base rate of 2.00%. This trade example will have a negative carry charge of 1.80% (I must pay the broker/liquidity provider). This is because I receive 0.20% per annum for the Euro’s I am buying but I must pay 2.00% per annum for the US dollars I am selling (0.20% – 2.00% = -1.8% per annum).
The difference in interest rates multiplied by the size of the position is the amount I will pay or receive. In this example that would equate to $36,000 per annum or $138.46 per day before borrowing costs. This amount minus borrowing costs is the total amount of carry for the position. If this number is positive, you will get paid to hold the trade position but if the number is negative then you must pay to hold the trade position.
Important! Most retail trading brokers will apply borrowing costs and interest rate differentials daily as a percentage that is priced as points (or pips) per standard lots traded. Carry charges therefore increase in line with position sizing and the amount you pay or receive from carry will increase as trade duration increases.
Central Bank Interest Rates.
The interest rate differential part of carry charges is determined by the central bank of the currencies you are trading. As explained, the difference between base rate of the currency you buy and the currency you sell is then multiplied by the volume you are trading and charged daily.
A list of the main central bank currency base rates can be found below.
Finding The Best Carry Trades.
Using the information shown above, you can then look for the FX currency pairs which benefit from the largest positive carry profiles for a trade position in a certain direction. Theoretically, the best carry trade using the FX currencies shown above would be a long position on the Turkish Lira vs Swiss Franc (TRYCHF). This is because the interest rate differential is the greatest of all the currency pairs.
The Swiss have the lowest central bank interest rates at (negative) -0.750% and the Turkish have the highest central bank interest rate at 9.750%. Therefore the interest rate differential is +10.50% per annum!
Yes, before borrowing costs are subtracted, you would receive 10.50% per annum on any TRYCHF long positions you might hold.
Total Carry Charge before borrowing costs = 9.750% minus -0.750% = 10.50%
If you were to buy $2mm worth of TRYCHF futures contracts you would receive $210,000 per annum or $807.69 per day in positive carry charges (before borrowing costs).
Important! Negative interest rates are now common. This further enhances the carry profile of an FX currency pair trade. If you were to sell a currency with a negative interest rate then theoretically you would still receive a payment.
Limitations (Borrowing Costs).
You may have noticed that I always mention the value of carry charges are before borrowing costs. This is important because borrowing costs vary between brokers and can change daily depending on the perceived market volatility and risk of the FX currencies involved.
Every single FX currency will incur borrowing costs so it is guaranteed that the raw base currency interest rate differential will not be the same as the total carry charges for a trade position. You will also often notice that the FX currency pairs with the largest carry profiles will also have the largest borrowing costs because of the risk associated.
It is no secret that the Turkish economy and financial situation is not the best. This is why the central bank interest rate is so high. They have to pay high interest rates in order to entice investors and savers in to giving them their cash.
As risk and volatility increases, borrowing costs increase and therefore the carry profile decreases.
Positive Carry Trade Example.
The chart above shows an example of a very good long term positive carry trade. I have listed the key facts and figures below.
- Trade Entry: 1st December 2008
- Trade Exit: 8th December 2014
- Duration: 2198 days / 6.02 years
- AUD Currency Base Rate: 3.00%
- Yen Currency Base Rate: 0.00%
- Assumed Averaged Interest Rate Differential: +3.00%
Using the figures above, it is possible to calculate the approximate returns of this long position carry trade. Using a simple support zone entry with a wide stop loss and exiting when a weekly lower high formed, the capital appreciation of the trade was 3.8R. For every £1 risked, the trade would have generated £3.80 of profit.
However, this trade benefited from positive carry charges. With a duration of over 6 years and an interest rate differential of +3.00%, a trader holding long AUDJPY positions through this period would have benefitted from more than 18% in positive carry charges (before borrowing costs).
Total Carry Charges = 3.00% x 6.02 years = 18.06% (minus borrowing costs).
The positive carry charges would have been over 4.7x larger than the capital appreciation of the trade itself. Turning a good trade in to an excellent trade!
Unfortunately, due to Covid-19 and the huge sell-offs seen across global equities, interest rates in many countries have been slashed dramatically. This now means that the once very attractive FX currency carry trades no longer exist.
For the past few years, EURUSD short positions have benefited from great positive carry fees thanks to the ECB having low interest rates and the US Federal Reserve offering over 2.00%. If you look at the chart below, it is very clear to see when the US cut rates this year.
As you can see, at the end of February 2020 when US interest rates were first cut, heavy USD weakness came in to the market and a lot of long term carry trade positions were exited swiftly. This sent the EURUSD FX currency pair rocketing and it gained almost 6% in just over 1 week.
This was a big move. As the chart shows, long term continuous selling over the past 3 years had provided a lot of short sellers with good carry trade positions until this benefit was then removed overnight. These traders then liquidated their short positions to lock in profits.
There are still positive carry trades out there on the FX currency markets but they are fewer and far between. Unfortunately it is likely to stay that way for some time until global markets recover and interest rates begin to rise once again.
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