The “Carry Trades” strategy is one of our favorite trading strategies, because with it you largely get profits by simply holding on to your positions (given that no significant market fluctuations occur). Various market fluctuations on the global markets after the 2008 financial crisis have significantly lessened the number of traders that follow this strategy. However, we have witnessed a resurgence of this strategy in the recent years, due to optimism rising, and market charts attaining a more stable appearance.
What is the idea behind carry trades?
In a nutshell, the carry trades strategy is based on making profits through differences between interest rates, that are set by each given country’s central banks regularly. What happens here, is basically “borrowing” a low-yield currency with leverage applied, in order to purchase a more high yield currency. In Forex terms, this means buying a currency by taking a long trade on a currency pair with a higher interest rate.
The most commonly used currency pair for such carry trades is the AUDJPY, due to Australia traditionally having a rather high interest rate when compared to other currencies. ON the other hand, Japan has a tendency towards rather low interest rates in the past few years, and often has the lowest interest rates out there. If you open a long trade on the AUDJPY pair using leverage, the next day you will receive a fixed rollover payout based on difference between the interest rates of these two pairs. In other trades, you will carry the trade over to the next day (hence the name “carry trades”), and reap profits magnified by leverage.
When are carry trades most effective?
In order for this strategy to work, the currency with a higher interest rate has to provide stable performance against the currency with a lower interest rate in the nearest foreseeable future. Thus, for profitable carry trading on the AUDJPY pair, the aussie has to either show tendency towards an uptrend, or at least a relative balance between the currencies. In our example however, there is no requirement of a strong uptrend for the Australian currency, and even a fragile balance can be sufficient. While good AUD performance will of course, be beneficial, it not compulsory, and this is exactly what makes this trading strategy beautiful.
As long as the interest rate of a higher yield currency maintains a high level, you may continue to earn money using such trades until this currency loses it’s advantage against the lower yield currency – in our case, a strong growth of Yen prices would most probably overshadow the profits from the difference between interest rates, or bring you to breakeven. History does know some cases however, where certain traders managed to maintain their carry trades open for months, and even years. This time period is only limited by however long the higher yield currency maintains a positive trend and the interest rate remains in most part unchanged.
Also, carry trading seems to work well during times when the market is very flat, and doesn’t show any significant trend. In addition to that, during periods of strong economic growth and low level of unexpected market events maintaining carry trades can become much easier, and interest rated often grow higher. The Japanese interest rate is at such a low level due to numerous efforts to stimulate the economy, while in Australia, the growth of inflation was so strong, that keeping it under control required higher interest rates to introduced. Such a dynamic brought along the formation of such a large (and very predictable, too) difference between interest rates of the two national currencies, along with it’s profitable trade opportunities.
High market volatility is the nemesis of carry trades
Since this strategy works so well when the markets are relatively flat, and when meager trends are easy to predict, it can be understandable why high volatility causes so many problems – it is very difficult to pinpoint which news event will be the tipping force behind the next erratic market movement.
Another problem, is that central banks may often decrease interest rates during times economic difficulties. As a more or less recent example, the Australians lowered their interest rates during the financial crisis of 2008, and this brought to an near disappearance of the difference between interest rates in the AUDJPY pair that we have discussed earlier. Leverage also played a role here, as it is a double edged sword, affecting your profits significantly, but also increasing risk exponentially during drawdown.
Many traders are quite optimistic towards the concept of carry trading, and are hoping for increasing stability in the markets. This is now surprise, given that this strategy is relative simple, easy to master, and at times very profitable, thus earning it’s fame of a convenient money-maker.