How to Use Carry Trading Strategy
1. Choose the most powerful currency pairs!
Many traders fail to consider the relative strength of both currencies displayed in the exchange rate. Without realising the economic status of currency pairs, it increases the probability of losing the trade.
If the currency pair you are trading belongs to countries with a good economy, the trading is most likely to fail as there is a mere movement. It depends entirely on the change in the relative currency.
Therefore, finding a good currency pair is the first step toward maximising returns. The good currency pair combines the “currency of a country with good economic conditions” and “currency of a country with bad economic conditions.”
The reason is to find a currency pair with strong trending movements. A currency with good economic conditions will increase its currency value. A currency with difficult economic conditions will fall, so the exchange rate movement, which shows the combined effect, will eventually shift in one direction. This can be seen as a trend in the end.
2. Carry Trade with leverage!
A carry-trade strategy is to sell low-interest monetary assets to form assets as high-interest financial assets. The carry trading strategy using leverage is one of the preferred strategies for global macro hedge funds and investment banks.
Aggressive investors do not hedge against these changes in investment because they can enjoy interest rate differences between the two currencies and bet on the exchange rate appreciation of high-interest currencies.
With leverage, the 2.5% interest rate difference between the two currencies could be 25%, considering the 10-fold leverage. However, leverage is very dangerous because, if not properly managed, we can also magnify losses.
Carry trading is the easiest way to utilise the basic economic principle of demand and supply in the market. Funds will flow into markets that provide the highest return on investment. In other words, a large amount of money flows into high-interest currencies, which increases the demand for their currencies.
These most common carry trades are straightforward to acquire. If you know and approach accurately, you can earn high profits without significant risk. But, carry trade also clearly has other risks. If you don’t understand when, why, or how you can effectively seal the carry trade, you can lose a lot of money.
How does the Carry Trade Proceed?
The way to implement the carry trade is to buy a high-interest currency and sell a low-interest currency on the contrary. Through the carry trade, investors can earn a difference in interest rates or a spread of interest rates between the two currencies.
STEP1: Let’s say the interest rate on the Australian dollar is 5%, and the interest rate on the Swiss franc is 1%.
STEP2: In this case, you can buy Australian dollars and sell Swiss francs to implement carry trade.
STEP3: If the exchange rate between the Australian dollar and the Swiss franc does not change at maturity, 5%-1% = 4% return.
STEP4: This yield is a return without leverage. If 10x leverage is used, it will increase to 40%.
BUY AUD → EARN INTEREST RATE → SELL CHF!
HOW TO EXECUTE?
STEP1: BUY AUD/CHF (Buy Australian dollar and sell Swiss franc).
STEP2: Australian dollar buying position: 5% interest income.
STEP3: Swiss franc selling position: 1% interest expense.
STEP4: 4% revenue assuming the exchange rate remains.
If the inflow of investors who have confirmed such opportunities, investors will profit from the exchange rate and the difference in interest rates. Importantly, to carry trade, buy a high-interest currency and sell a low-interest currency is the fundamental idea.
How does Carry trade Occur?
Carry trade occurs when capital between countries repeats inflows and outflows consistently. Interest rates are a measure of which country is more attractive to investors than in other countries. Countries with the right economic conditions (high growth, high productivity, low unemployment, income improvement, etc.) will give high-profit to those who want to invest in those countries.
In other words, countries with high growth expectations can provide high profits enough to those who support their own countries. Usually, investors look for investments that give them high returns to maximise profits.
Countries with low growth and productivity will not be able to provide high returns to investors. In reality, some countries show poor economic conditions that cannot offer any return on investment, which means that interest rates are zero or close. This difference in interest rates between the two currencies makes it possible to carry trade.
For Example,
1. If you deposit in Swiss francs, it will give you 1% interest.
2. If you deposit in Australian dollars, it will give you 5% interest.
3. Australian dollars have a higher interest rate than Swiss francs.
4. Investors sell the Swiss franc and buy the Australian dollar.
5. As a result, a 4% return can be obtained from the purchase of an Australian dollar deposit that pays 5% interest.
This transaction of investors sell Swiss franc and buy the Australian dollar is named carry trading. If many market participants are making these transactions, it will naturally shift capital from Switzerland to Australia to earn interest. This inflow of capital increases demands the Australian dollar, causing the currency to rise.
More About Carry Trading
1. How Many Risks Should I Take?
Investors who actively take risks are said to be high-risk takers or risk-preferred. Conversely, investors who are conservative and willing to take less risk are low-risk takers.
Carry Trading is the most profitable when investors have a high risk-taking tendency. Buying a currency that pays high-interest rates is eventually taking risks for investors. Risk refers to uncertainty about whether a country’s economy can continue to be in good shape and continue to pay high-interest rates.
There is a possibility that something will happen to stop a country from paying high-interest rates. Consequently, investors are willing to take these risks. If investors are unwilling to accept these risks, capital will not move from one country to another, and the opportunity for Carry Trading will not be there. Therefore, a group of investors must have a high risk-taking tendency or be willing to take risks in investing in high-interest currencies.
2. When Should I Stop Carry Trading?
Carry Trading is the least profitable when investors have a low risk-taking tendency. When market participants hesitate to invest in high-risk currencies that pay high-interest rates, they invest in safe asset currencies that pay low-interest rates. This shows precisely the opposite direction of Carry Trading, buy low-interest currencies and sell high-interest currencies.
Other Things to Keep in Mind!
Identifying risk-taking tendencies is an essential part of the carry trade, but this is not necessarily the only consideration. Below are the other things we need to consider.
1. The Strength of Low-Interest Currencies
By implementing the carry trade, investors can earn profits from the difference in interest rates between high and low-interest rates or spread. However, you may lose earnings if the low-interest currency strengthens for some reason, like a better economic situation. The ideal moment to Carry Trade is when low-interest currency countries have low economic growth forecasts or poor economic conditions.
2. Trade Balance
The difference between a country’s trade balance, namely exports and imports, also affects Carry Trading’s profitability. In general, if investors have a high risk-taking tendency, capital flows from low-interest countries to high-interest countries, but it is not always the case.
The U.S. currently maintains low-interest rates but attracts a lot of capital from other countries. This is the same, even if investors have a high risk-taking tendency. The reason why this happens is that the U.S. has a considerable trade deficit. Since imports are higher than exports, the United States must import capital from other countries to cover the trade deficit.
The U.S. is attracting foreign capital without a doubt. This illustrates that even if investors have a high risk-taking tendency, an imbalance in the trade balance can cause a rise in the value of low-interest currencies. If the value of low-interest currencies (selling currencies) appreciates, this will negatively affect the carry trade’s profitability.
3. Investment Period
In general, Carry Trading is a long-term investment strategy. To implement the carry trade, the investor must consider an investment period of at least six months. This investment period is to be taken into account because the carry trade is not affected by the noise generated by short-term exchange rate fluctuations. Also, suppose leverage is not used significantly. In that case, the position can be held for a long time and helps overcome market fluctuations.