subject: Learn Carry Trading [print this page] 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.
Now, someone living in Tokyo will obviously have a bank account in Japanese Yen (JPY). In the last decade, the interest rate in the Japanese economy was almost close to zero as the Japanese Central Bank (JCB) wanted to boost the Japanese economy out of it's decade long deflation.
Now, you are sitting in US thinking of what to do with your US Dollar (USD) deposit with the bank. The bank is only paying 2.5% annual interest. Suddenly, your friend tells you about carry trading and explains everything to you. So you buy AUD and sell JPY with the USD. Now this means you are long on AUD and short on JPY. Buying AUD gives you the right to get 4.5% annual interest while selling JPY obligates you to pay 0.1% annual interest. So the net annual return that you make with going long on AUD and short on JPY is 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!
by: Ahmad Hassam
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