How does carry trade work in the forex market

With Carry Trade Strategy in forex, you benefit from interest differential.

When you trade currency,  you pay interest whenever you sell a currency and you are paid interest for holding/buying a currency.

You are often told or the first time you enrolled here at FreeForexCoach , you learnt that currency is only traded in pairs.

For instance when you choose to buy or sell a pound, it always has a counter currency.

This means without a counter currency your trade cannot happen.

What do I mean??

A currency pair comprises of a base currency and a counter currency.

For example GBP/USD, USD/JPY or NZD/USD and so many others.

So when you buy GBP/USD or any currency pair, you are actually buying GBP at the same time selling USD.

The transaction is at a fixed contract size and the exchange rate at that period.

When you do that, you are borrowing the USD to purchase the GBP.

Like we said, with carry trade, you benefit from interest differential.

If you buy a currency with a higher interest rate than what you sell, you have a positive carry trade

On the other hand, if you buy currency with less interest rate than what you sell, then you have a negative carry trade.

Positive carry trade

Positive currency carry trade is therefore selling currency with lower interest rate to purchase a currency with a high interest rate.

With Positive carry trade, you make money  even when the price of the pair stays the same during the time you are in the Forex carry trade.

In case the trade moves to your favor during the time of carry trade, you will not only earn carry interest but also capital appreciation of currency.

Negative Carry trade

Negative carry trade is selling a currency with a high interest rate while buying a currency with a low interest rate.

Here you make money when the lower interest currency appreciates relative to the higher interest rate currency.

The gain should be enough to offset any other costs involved.

How carry trade works in forex trading

To trade Forex, you must have a broker. Your broker closes all your open positions at the end of each day.

As of the fact, you are already aware that the Forex market operates 24 hours a day, 5 days a week. Yes, that’s all true.

However,

Even though the market is open 24 hours a day, your broker will close and reopen your positions at the end of each day.

He then either credit or debit you with the difference in the overnight interest rate of the currency you sold and the currency you bought.

 I suppose you some times see a less value on profit or higher loss after closing out a trade.

This is known as the Forex swap.

Brokers use the Forex swap to show traders their interest rate differential payout or charge.

It is either a positive swap or a negative swap.

How do you see Forex swaps on your open trades

On MT4 trading platform, go to the upper bar above the chart to the left.

Select the terminal icon.

Then click on Trade option.

Hoover around the display, you will see the column section for Swaps. 

From the terminal, you will realize that some trades have swaps and others don’t.

Currencies in a pair with almost the same interest rate literally have zero swap.

In addition, If you open and close a trade on a Forex pair within the same day then there is no swap on that trade.

Leveraged Carry Trade Example

Let’s say you open a trade on a min lot, equal to 20,000 units of currency.

To open this trade, your broker requires you to have only $400 as margin.

Contributing only $400 over $20000 you need to hold a trade means your broker lent you $19600 at a leverage of 50:1.

If you choose to trade a currency pair with a positive carry,

You will earn daily interest on the $20,000, not $400

On the other hand,

If you trade a currency pair with a negative carry, you will have to pay the daily interest on the $20,000.

The $19600 is the amount you borrowed from your broker to finance your trade.

The $400, is the collateral you need to borrow $19600 from your broker.

Carry trade strategy in forex also has some risks involved especially when you take a trade and price goes against you .

It’s likely to wipe off all your earnings due to fall in value of currency and the leverage used.

Therefore, you don’t to open a trade just because of its interest differential.

You should first of all consider the available market conditions for the pair.

For example, the level of risk in the market, major fundamental factors and  technical factors.

Conclusion

In order to benefit from carry trade strategy in forex,

Chose a currency pair that is stable.  The currency pair should be in an uptrend favoring the high yielding currency.

Unlike other investment assets, spot Forex market closes at the end of the day and rollover is automatically done on open positions held at that time.

The market normally closes at 5 pm, New York time or 9 pm GMT and the new day officially begins

. Because you are holding positions overnight, you always receive interest on the currency you bought  and pay interest on the currency sold.

Your broker credits or debits the difference to your account as he re- opens your positions. He adds or subtracts pips to the trade.

We shall talk more about a rollovers and swaps in the next lesson.