Carry Trade Lesson 1

In this video we’re going to talk about the carry trade. Simply put, a carry trade is a
long-term position where a trader attempts to earn interest as well as capital gains
on their positions. To set the stage, we need to begin by establishing an
understanding of rollover, as this is a major component of the carry trade. This is the
interest component.

Rollover is the interest earned or paid for holding a position overnight or into the
next trading day. Each currency has an interest rate associated with it, and because
FX is traded in pairs, every trade involves not only two different currencies, but their
two different interest rates. So let’s talk about why certain trades earn rollover and
why other trades have to pay rollover interest. If you buy the EUR/USD, you are
essentially buying the EUR and selling the USD. If you sell the EUR/USD, you are
selling the EUR and buying the USD. If the interest rate on the currency you bought
is higher than the interest rate on the currency you sold, then you will earn rollover
interest.

So in this case, we’re essentially borrowing (or selling) currency at a low interest rate
in order to invest (or buy) into a currency that yields a higher interest rate. If the
interest rate on the currency you bought is lower than the interest rate on the
currency you sold, then you will have to pay rollover.

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 Carry Trade Lesson 1

Again, in this case you’d be borrowing (or selling) currency at a relatively high
interest rate to invest (or buy) into a currency that yields a lower interest rate. With
all this said, how do you know how much interest you will have to pay or earn when
you do hold positions long-term.

Fortunately, you don’t have to calculate rollover rates yourself, as the FXCM Trading
Station II automatically calculates and reports all rollover for you and the rollover
rates can be found from the Simple Dealing Rates window of the platform in the Roll
S and Roll B columns. We can see here that by buying the AUD/USD currency pair, a
trader would earn $3.67 in interest every day at the 5PM Eastern close for each 10K
lot open.

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 Carry Trade Lesson 1

Understanding the role that interest rates play in the FX market is a crucial task in
becoming a successful carry trader. There is a lot to understand regarding interest
rates and interest rate environments and we’ll cover the basics now. However, for a
more detailed understanding make sure to watch our part 2 video on the carry trade.

A country offering high interest rates will typically attract more capital as investors
seek to capitalize higher returns. As interest rates rise, investments will follow, which
can in turn increase the value of the currency. In most cases, a higher interest rate
will usually lead to higher currency value, while a lower interest rate will usually
lead to a lower currency value.

A carry trader's focus then becomes the expectation on the direction of the country's
interest rate, to ensure their high rate of return. This is a little different than just
checking to see the two interest rates and assuming that the market will go with the
currency with the higher interest rate. Traders prefer to own the currency with the
higher interest rate that continues to rise and prefer to sell the currency with lower
interest rate that continues to fall. So it is also the expectation of future interest
rates that traders use in their trading approach.

So carry traders anticipate future interest rate moves in their decision on what pair
to buy or sell as much as they depend on the current interest rate environment. But
it doesn’t make much sense to buy a pair that is in a downtrend just to earn interest.
Making $3.67 in interest a day only to lose $100 a day in market movement will not
lead to consistent profits.

So it is also important to note the direction of the daily trend and to only trade in
that same direction. When you are trading with the trend and at the same time also
earning interest, it can be very profitable. The daily trend of the AUD/USD is up and
by buying this pair you can also earn $3.67 a day in rollover interest. This is a
situation a carry trader looks for in a trading opportunity. But let’s go through the
process of identifying the best candidates for a carry trade to see if there are any
better opportunities.

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 Carry Trade Lesson 1

The first thing we want to note is the pairs that offer the highest rollover interest
credits. We start off by checking the Simple Dealing Rates window on the Trading
Station for this input.

We only want to note the positive numbers as that represents what we can earn.
Those numbers that are negative are what we would have to pay on a daily basis for
an open position. Under the Roll S column we can see where the EUR/AUD shows
6.39 while the GBP/AUD shows 6.92. This is what we could earn for each 10K lot
sold since the S in Roll S means sell. This account is funded in USD, so we can earn
$6.92 a day for every 10K lot of the GBP/AUD we sold.

In the Roll B column we can see what the debit or credit would be for each 10K lot
that was bought. We can see that we could earn $4.27 a day for each 10K lot of
AUD/JPY we bought or $4.00 a day for each 10K lot of AUD/CAD that we would buy.
These are the four highest totals which is the something we recommend doing as the
first step when looking for a carry trade.

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 Carry Trade Lesson 1

The next step is to identify the strong trending moves that support the carry trade.
Let’s start with the GBP/AUD currency pair. Remember that we earn $6.92 a day for
every 10K lot that we sell, so we want to make sure that the trend is down to
increase our chance of success on this trade. Remember, the idea is to earn interest
and to be in a profitable trade at the same time. Here is a daily chart of the
GBP/AUD and you can clearly see that the trend is down:

This daily chart with one year of trading shows a strong downtrend noted by a series
of lower highs and lower lows. This is the situation we look for in a carry trade in
that there is a strong possibility of earning interest in addition to being in a profitable
sell position. Let’s take a look at another potential trade.

This is the daily chart of the EUR/AUD with one year of trading plotted.

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 Carry Trade Lesson 1

This is another good example of a downtrend with a series of lower highs and lower
lows. The trend is not as strong as we saw on the GBP/AUD, but it is a worthy carry
trade opportunity just the same. In addition to potentially profiting with an open sell
position, we could also earn $6.39 a day in interest for every 10K lot that we hold
short. Let’s look at one more chart to compare the differences.

This is a daily chart of the AUD/JPY with one year of trading.

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 Carry Trade Lesson 1

We can see a nice uptrend which does support our carry trade. This pair generates
$4.27 a day in interest for every 10K lot bought. The trend supports the trade since
we can potentially profit from the move up at the same time.

These are all examples of carry trades that we want to be looking for. Hopefully you
can now see why the carry trade can be so popular. But before closing this video,
let’s recap what we’ve talked about by going over what to watch out for when setting
up a carry trade:

 Number one, make sure you first note the largest credits in the Simple
Dealing Rates Window of the FXCM Trading Station.
 Then start with the highest amount you can earn and look for strong trends
in that same direction.
 When you enter into the trade, always trade with a protective stop in the
market for those times when the market reverses and moves against your
position.
 Next make sure you use a solid method for identifying your entry and exit.
Do not just buy or sell based on the rollover credits alone.
 Try to stay in the trade as long as possible. Time is your friend in a carry
trade since we are looking for that interest rate component.
 Be aware of a change in direction of the interest rate environment. Even
though a pair may still offer a nice interest credit, the trend can change at
any time based on future interest rate expectations.
 Finally once you are in your trade, manage the trade without regard to the
interest that is being earned. A move against your position can quickly offset
any interest you have earned.

We’ve covered a lot in a short period of time and there is quite a bit more to
cover on this topic. So make sure to watch our part two video for more in-
depth information on trading the Carry Trade.

Thanks for watching and good luck with your trading.

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