How Does the Carry Trade Work?

In this post, I'll explain how the carry trade works in Forex trading, the risks and the benefits. I'll also show you how to backtest it, if this is something that you're interested in trading.

The Carry Trade Explained

A carry trade is when you borrow a currency that has a low interest rate, then use that money to buy another currency that pays a higher interest rate.

You make money on the difference between the interest rates.

In order to see the interest rates for each currency, you can look at any up-to-date list of central bank interest rates.

Here's a good one from FXStreet.

SEE ALSO: A Weird Forex Hedging Strategy

For example, if you did a carry trade where you borrowed Swiss Francs and bought US Dollars, you would be making money on the interest (also known as rollover) because the interest rate of the Federal Reserve is higher than the interest rate of the Swiss National Bank.

How much would you make, you ask?

Well, you can just jump over to a rollover calculator and figure it out. Most brokers have one.

This is an example from Oanda.

So if you went long a standard lot of 100,000 currency units of USD/CHF and held it for 24 hours, you would make $6.16 in interest.

One important thing to note is that the interest rates listed on the Oanda website are different from the actual central bank interest rates.

This is because all brokers reduce the interest rate on both sides as a transaction cost. It's like the spread on a trade.

Check with your broker to see their rates because it could be very different from the central bank rates.

But it sounds like easy money, right? You just sit around on the beach and collect the interest…like a bank.

That's what some websites would like you to believe.

But it's not really that easy.

Here's why…

Is the Carry Trade Safe?

I cringe whenever I see websites mention that the carry trade is low-risk.

It's not.

You can actually get into a lot of trouble with the carry trade, especially if you are leveraged.

When I interviewed professional Forex trader Kim Krompass, she mentioned that her first big blowup happened when she was only doing carry trades.

The reason it's not safe is because although your interest rate is risk free, there is still position risk in your trade.

Let's say that you went long USD/CHF, like in the example above…

…then this happened.

That's about 1,800 pips in a matter of a few hours. If you were long a standard lot (100,000 units), you would have been down approximately $22,000 during that move.

At $6.16 per day in interest, it would take you almost 10 years to make up that loss.

As you can see, the carry trade is far from risk-free.

However, if you manage your risk properly and enter the market at a good spot, it can be possible to build up a nice interest-bearing position, while minimizing your position risk.

If you want to learn how I do this, check out my Zen8 trading method.

Now that you understand how the carry trade works, I'll answer a few commonly asked questions about this trade.

What is Positive Carry?

Positive carry means that you are making money on the interest rate differential between the two currencies you are trading. Negative carry means that you are losing interest on the trade.

Remember that positive carry should never be an excuse to stay in a losing trade.

Always consider your position profit or loss first.

Who Should Worry About Negative Carry?

If you are a day trader or trade short-term, then you probably don't have to worry about negative carry. However, if you are a position trader and will hold your position for months or even years, then rollover needs to be considered because the interest can add up.

What is the Japanese Yen Carry Trade?

The Yen carry trade refers to a trade where you borrow Japanese Yen and buy higher interest rate currencies like the US Dollar. This trade was popular in the early 2000s. It's said that many Japanese housewives used it as a way to invest their family's money during a time of zero interest rates in Japan.

Should I Trade the Turkish Lira?

At this point, you're probably looking at the interest rates of central banks around the world and trying to figure out the biggest spread. Naturally, the Turkish Lira stands out because at the time that this blog post was first written, the Lira has an interest rate of 24%.

Well, it's high for a reason…

Countries with higher interest rates are generally less stable. Therefore, they also have larger position risk because big moves can happen suddenly, liquidity is lower and spreads are wider.

Here are examples of countries with higher rates:

Russia: 7.75%
Mexico: 8.25%
Egypt: 14.75%
India: 6.25%

Even though it's tempting to trade these currencies, the risk isn't worth the reward. Stay with the major central banks, the carry trade is risky enough.