Forex Strategies: The Carry Trade

Forex, like stocks options, is a trading vehicle that moves far beyond the basics of win, lose or break-even. 

I first saw the carry trade in action in the hands of a Ukranian friend, who used it brilliantly to illustrate on the difference between the smart money, that looks for high probability strategies, vs. the dumb money, which puts all the chips on red with crossed fingers.

The education team at Forex Traders tells how the smart money does it, and how you can profit from the carry trade. -- Tim

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By Joel Arnold, Analyst
Forex Traders

One very common forex trading strategy is called the carry trade. This method is a longer term method and also involves a significant amount of research. This article is a guide to the nature of carry trades—how they work.

The concept starts with interest rates: money paid over time for the privilege of holding someone else’s money. However, carry trades take advantage of the difference between interest rates. Using something we’re more familiar with, the concept works like this:


Maybe you get an introductory credit card offer with rates of only 2% for a year. Then you notice that your bank has CDs at 5%. You might defer your expenses to the card for that year (essentially borrowing from the credit card company) and invest that money into CDs. You keep the 4% difference of interest rates between the two. While that does work (in fact, I’ve done it), it’s going to be small. Even if you got $5,000 of credit, it would still only work out to $200.

So some investors use this strategy on the forex market. Here, they simply look for currencies with a interest rate differential. For instance, a forex trader might use a currency pair involving one currency with a low interest rate and another with a much higher rate. If he buys the high-interest currency using the low-interest currency, he might be able to collect on the difference.

This has a natural limitation, since the difference between interest rates is generally relatively small—often less than the 4% in our previous example. But what makes this workable is the high amounts of margin available in forex trading, allowing an investor to leverage his returns, magnifying the results many times over. In other words, by trading on a 10% deposit, you might buy contracts worth 10 times your initial investment (10:1 leverage). If you could manage an interest rate differential of 3-4%, it would leave you with a total of 30-40%. Not bad, if you could count on it. In a separate article, we’ll talk about the realities of carry trades and why it doesn’t work out quite so simply.

Of course, interest rates only work out over time, making this strategy an inherently longer-term method. This explains the term “carry trades.” In the event that you carry a position overnight, the broker can charge you a carrying fee. This is because the broker has to pay the overnight interest rate on the currencies you held. However, depending on your position, this can also result in your making money and a credit from the currencies you held. This is the way that carry trades work.

So we could break the process down into three steps:

1. You borrow money in a country with cheap interest rates.
2. You use the loan to buy currency in another country with high interest rates. As the interest grows, you enjoy the proceeds.
3. When you’re ready to exit, you sell the high-interest currency you held and pay your loan with the original (low interest) currency. The difference between the two interest rates is your profit.

Of course, this method depends heavily on leverage, and wherever high leverage is involved, there is also high risk. Remember that if you can make money, you can also lose it, and generally just as fast.

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