In our previous lesson, we learned about the best times to trade and when not to. In this lesson, we’ll delve deeper and talk about technical criteria that you should consider when carry trading.
Lesson overview
- To execute a carry trade, a currency pair must have a high interest differential, and the higher-yielding currency must be stable or in an uptrend.
- You can set a stop order on a carry trade, like regular trades, to limit losses.
Criteria for Carry Trading
In our earlier lessons, we said that carry trading follows the very simple but very effective principle in forex, “buy low, sell high.”
To do this, a trader must follow two criteria when carry trading.
First, the currency pair should have a high interest differential.
Second, the pair must be stable and/or the higher-yielding currency must be in an uptrend. If the higher-yielding currency is in an uptrend for longer, you can stay in the trade as long as possible and maximize profit from the interest differential.
The criteria is pretty simple, but let’s see in action with the example below.
Real-Life Example of Carry Trading
Let’s take a look at two carry trade examples, one where the higher-yielding currency is stable, and the other where the higher-yielding currency is at an uptrend.
Stable higher-yielding currency
This is a one-week chart of the Mexican Peso (MXN) and Japanese Yen (JPY) currency pair. During this time, the MXN interest rate is at 10.75%, while the JPY interest rate is at 0.25%. While the exchange rate for MXN/JPY is at 7.60.
As you can see below, the exchange rate is pretty stable.
That means, if a trader invested in a carry trade for MXN/JPY for a year, if interest rates remain the same, they would earn the 10.50% interest rate differential in full.
Okay, let’s bring in the numbers!
- Say you borrowed 500,000 JPY with a leverage of 10:1.
- That means you get to convert JPY 5,000,000 into MXN 656,358.
- You then invest your MXN in a Mexican bank with a 10.75% interest rate.
- After a year, you get MXN 70,558.49 from your initial investment!
- Now you can pay back the interest from your borrowed JPY which is only JPY 1250 or MXN 164.
- That leaves you with a net profit of MXN 70394.49 as exchange rates remained stable.
Uptrend higher-yielding currency
But what about a currency on an uptrend?
In principle, it’s entirely the same, but your profits may exponentially increase because of a rising exchange rates.
Let's examine this 3-year chart of the Canadian Dollar (CAD) and the Japanese Yen (JPY).
As you can see, exchange rates have been on an uptrend for the past three years. You expect that the trend will continue, so you executed a carry trade in 2023.
Let’s assume that you executed a carry trade in June 2021 when the exchange rate was around 88.00 and the CAD interest rates were at 0.25% while the JPY was –0.1%.
Let’s assume the following scenario:
In June 2023, the CHD/JPY exchange rate is at JPY 100. You borrowed JPY 10,000 with a 1:10 leverage and a 0.1% interest rate. You then convert it to CAD and are able to invest CAD 10,000 in a Canadian bank with a 4.5% annual interest.
A year later, let’s assume that the exchange rates remained the same, but the exchange rate shot up to JPY 120. You decide it’s time to reap the benefits of your investment.
At this point, you are able to liquidate your 4.5% interest rate CAD investment to a total of CAD 10,450.
You convert it back to JPY as JPY 1,245,000. Upon paying back your borrowed JPY (10,000) + a 0.1% interest (10), you earn a net profit of JPY 1,243,990.
Not bad! During an uptrend currency pair, you get to profit from the interest rate differentials as well as the increase in exchange rates.
How to Manage Risk In a Carry Trade?
In our two previous examples, we assumed a hypothetical world where the interest rates did not change.
However, this is often not the case in the real world. One of the major risks of carry trading is that interest rates are always subject to change. Countries announce new interest rates every year.
Additionally, exchange rates are also very volatile. Even if the interest rates remain the same, but exchange rate trends suddenly reverse, it might mean a major loss for you.
To be successful in carry trading, you must always have a risk management plan.
When executing a carry trade, you can limit your losses like a regular trade.
You can do this by setting a stop order to close your position at a specific loss.
This lesson concludes our module for Carry Trading.
Ready for the next topic? In the next module, you’ll get to learn about Trading Journals!
