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Level 6 Trading - Carry Trade

Carry Trade
Another popular trading strategy among currency traders is the carry trade. The carry trade is a strategy in which traders borrow a currency that has a low interest rate and use the funds to buy a different currency that is paying a higher interest rate. The traders' goal in this strategy is to earn not only the interest rate differential between the two currencies, but to also look for the currency they purchased to appreciate.

Carry Trade Success
The key to a successful carry trade is not just trading a currency with high interest rate and another with a low interest rate. Rather, more important than the absolute spread between the currencies is the direction of the spread. For an ideal carry trade, you should be long a currency with an interest rate that is in the process of expanding against a currency with a stationary or contracting interest rate. This dynamic can be true if the central bank of the country in which you are long is looking to raise interest rates or if the central bank of the country in which you are short is looking to lower interest rates. There have been plenty of opportunities for big profits in the past in the carry trade. Let's take a look at a few historical examples. (To learn more, read Currency Carry Trades Deliver)

Between 2003 and the end of 2004, the AUD/USD currency pair offered a positive yield spread of 2.5%. Although this may appear small, with the use of 10:1 leverage the return would become 25%. During that same period, the Australian dollar also appreciated from 56 cents to close at 80 cents against the U.S. dollar, which represented a 42% appreciation in the currency pair. This means that if you were in this trade you would have profited from both the positive yield and the capital gains.



Figure 1: Australian Dollar Composite, 2003-2005
Source: eSignal


Let's take a look at another example, this time looking at the USD/JPY pair in 2005. Between January and December of that year, the USD/JPY rallied from 102 to a high of 121.40 before settling in at 117.80. This is equal to an appreciation from low to high of 19%, which was far greater than the 2.9% return in the S&P 500 during that same year. Also, at the time, the interest rate spread between the U.S. dollar and the Japanese yen averaged approximately 3.25%. Without the use of leverage, this means that a trader could have potentially earned as much as 22.25% in 2005. With 10:1 leverage and that could have been as much as 220% gain.



Figure 2: Japan Yen Composite, 2005
Source: eSignal



In the USD/JPY example, between 2005 and 2006, the U.S.Federal Reserve aggressively raised interest rates 200 basis points from 2.25% in January to 4.25%. During the same period, the Bank of Japan left interest rates at zero. Therefore, the spread between U.S. and Japanese interest rates grew from 2.25% (2.25% - 0%) to 4.25% (4.25% - 0%). This is an example of an expanding interest rate spread.

Conclusion
The main thing to look for when looking to do a carry trade is finding a currency pair with a high interest spread and finding a pair that has been appreciating or is in an uptrend. Also, understanding the underlying fundamentals behind interest rates changes is one of the keys to implementing a carry trade. The next section will introduce you to the all-important concept of money management within your forex account. (If you require a refresher on interest rates, go back to section 5.3 on interest rates or refer to Trying To Predict Interest Rates)

Money Management


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