What Is Carry Trading?
How about carry trading? Have you ever given carry trading strategy a thought? Carry trading is one of the most popular passive long term trading strategy that is frequently employed by big banks, institutional investors, corporations, hedge funds and pension funds. Millions of retail investors also use carry trading to grow their wealth over time. Why you would keep your money in a bank account if you can make more through carry trading?
So how does carry trading works? When you keep your money in a bank account, the bank is supposed to pay you a certain return based on the interest rate of that currency. Let's take the example of Australian Dollars (AUD). Some years back, the Australian banks were paying something like 4.5% annual interest on bank account.
Similarly,for someone living in Tokyo, Japanese Yen (JPY) is the most important currency. In 1990s, Japanese economy was suffering from stagflation. In order to take the economy out of this situation, Japanese Central Bank (JCB) almost reduced the interest rate to zero. It was something like 0.1% ( only 1 basis point). Now when a Japanese deposited JPY in a saving account, he or she got only 0.1% annual interest on the deposit. It was better to spend than to save. This was exactly the purpose of lowering the interest rate to zero by JCB.
Suppose you go long on AUD and short on JPY meaning that you buy AUD and sell JPY. Now owning AUD means that you will get an annual interest of 4.5% while owing JPY means that you will have to pay an annual interest of let's say 0.1%. So the net annual return that you will get will be 4.5-0.1= 4.4%.
So you are making 4.4% annual return now. Now, you haven't even thought of using leverage. You become greedy and want to further increase your annual return. You decide to use a leverage of 1:5 meaning for every $1 in your account, the broker is going to pay $5. This leverage multiplies your annual return with 5 and makes it 22%. Now, you get even more greedy and decide to use a leverage of 1:10. This will multiply your annual return to 44%. Fantastic, isn't it!
Leverage is a double edged sword. When things work for you, leverage is great but when they don't, leverage will ruin you. So be careful with leverage. What I mean is that we have assumed that both the currencies don't appreciate or depreciate during this period. If they do, it can work for you as well as against you. Let's see how!
Now, when millions of people do carry trading seeing the interest rate arbitrage opportunity between the two currencies AUD and JPY, the net effect will be more demand for AUD and less demand for JPY. AUD will tend to appreciate relative to JPY. This appreciation of AUD will work for you and increase your net annual return. This is what normally happens when people are willing to do carry trading.
However, good times never last forever. Remember 2008, when everything came crashing down. When the market sentiment turns negative, interest rates are suddenly lowered and risk aversion increases, suddenly now millions of people are now trying to unwind carry trading and sell AUD. AUD plus interest differential is also zero or negative so you lose! But this is the name of the game. As long as you keep on monitoring the situation daily for 15-30 minutes and are ahead of the crowd, you don't have to worry!
About the author
Mr. Ahmad Hassam has done Masters from Harvard .Discover the best Forex Robot! If you want a 5 figure monthly income part time than give 60 days RISK FREE trial to Forex Income Engine 2.0 Course by Bill Poulos - A Flexible Forex Day Trading System that requires you to trade not more than 20 minutes a day. It comes with 8 weeks of FREE personal coaching by Bill.
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