A carry trade is when you borrow one financial instrument (like USD currency) and use that to buy another financial instrument (like JPY currency).
While you are paying the low interest rate on the financial instrument you borrowed/sold, you are collecting higher interest on the financial instrument you purchased.
Your profit is the money you collect from the interest rate differential.
This is another way to make money in the forex market without having to buy low and sell high, which can be pretty tough to do day after day.
Carry trades work best when investors feel like taking on risk. Current economic conditions need not be good, but the outlook does need to be positive.
If a country’s economic prospects aren’t looking too good, then nobody will be prepared to take on the risk.
To put it simply, carry trades work best when investors have low risk aversion.
Carry trades do not work well when risk aversion is HIGH.
When risk aversion is high, investors are less likely to buy higher-yielding currencies or likely to reduce their positions in higher-yielding currencies.
When economic conditions are uncertain, investors tend to put their investments in safe haven currencies, which tend to offer low interest rates like the U.S. dollar and the Japanese yen.
It’s pretty simple to find a suitable pair to do a carry trade. Look for two things:
Find a high interest differential.
Find a pair that has been stable or in an uptrend in favor of the higher-yielding currency. This gives you the ability to stay in the trade AS LONG AS POSSIBLE and profit off the interest rate differential.
Always remember that economic and political factors are changing the world daily.
Interest rates and interest rate differentials between currencies may change as well, bringing popular carry trades (such as the yen carry trade) out of favor with investors.
So when doing a carry trade, you should still limit your losses like a regular directional trade.
When properly applied, the carry trade can add significant income to your account, along with your directional trading strategies.
It’s pretty simple to find a suitable pair to do a carry trade. Look for two things:
Find a high interest differential.
Find a pair that has been stable or in an uptrend in favor of the higher-yielding currency. This gives you the ability to stay in the trade AS LONG AS POSSIBLE and profit off the interest rate differential.
Pretty simple, huh?Let’s take a real life example of the carry trade in action:
This is a weekly chart of AUD/JPY. Up until recently, the Bank of Japan has maintained a “Zero Interest Rate Policy” (currently, the interest rate stands at 0.10%).
Also known as ZIRP.With the Reserve Bank of Australia touting one of the higher interest rates among the major currencies (4.50% in the chart example), many traders have flocked to this pair (one of the factors creating a nice little uptrend in the pair).
From the start of 2009 to early 2010, this pair moved from a price of 55.50 to 88.00 – that’s 3,250 pips!
If you couple that with interest payments from the interest rate differential of the two currencies, this pair has been a nice long term play for many investors and traders able to weather the volatile up and down movements of the currency market.
Of course, economic and political factors are changing the world daily.
Interest rates and interest rate differentials between currencies may change as well, bringing popular carry trades (such as the yen carry trade) out of favor with investors.
Carry Trade Risk
Because you are a very smart trader, you already know what the first question you should ask before entering a trade is right?
“What is my risk?”
Correct! Before entering a trade you must ALWAYS assess your max risk and whether or not it is acceptable according to your risk management rules.
In the example at the start of the lesson with Joe the Newbie Forex Trader, his maximum risk would have been $9,000. His position would be automatically closed out once his losses hit $9,000.
Eh?
That doesn’t sound very good, does it?Remember, this is the worst possible scenario and Joe is a newbie, so he hasn’t fully appreciated the value of stop losses.
When doing a carry trade, you can still limit your losses like a regular directional trade.
For instance, if Joe decided that he wanted to limit his risk to $1,000, he could set a stop order to close his position at whatever the price level would be for that $1,000 loss.
He would still keep any interest payments he received while holding onto the position.
Carry trades work best when investors feel risky and optimistic enough to buy high-yielding currencies and sell lower-yielding currencies.
It’s kinda like an optimist who sees the glass half full. While the current situation might not be ideal, he is hopeful that things will get better.
The same goes for carry trade.Economic conditions may not be good, but the outlook of the buying currency does need to be positive.
If the outlook of a country’s economy looks as good as Angelina Jolie or Brad Pitt, then chances are that the country’s central bank will have to raise interest rates in order to control inflation.This is good for the carry trade because a higher interest rate means a bigger interest rate differential.
When Do Carry Trades NOT Work?
On the other hand, if a country’s economic prospects aren’t looking too good, then nobody will be prepared to take on the currency.
Especially if the market thinks the central bank will have to lower interest rates to help their economy.
To put it simply, carry trades work best when investors have low risk aversion.
Carry trades do not work well when risk aversion is HIGH (i.e. selling higher-yielding currencies and buying back lower-yielding currencies).
When risk aversion is high, investors are less likely to take risky ventures.
Let’s put this into perspective.
Let’s say economic conditions are tough, and the country is currently undergoing a recession. What do you think your next door neighbor would do with his money?
Your neighbor would probably choose a low-paying yet safe investment then put it somewhere else. It doesn’t matter if the return is low as long as long as the investment is a “sure thing.”
Finding yield is not the priority anymore. preserving principal is.
This makes sense because this allows your neighbor to have a fallback plan in the event that things go bad, like if he loses his job.
In forex jargon, your neighbor is said to have a high level of risk aversion.The psychology of big investors isn’t that much different from your next door neighbor.
When economic conditions are uncertain, investors tend to put their investments in safe haven currencies that offer low interest rates like the U.S. dollar and the Japanese yen.
If you want a specific example, check out Forex Gump’s Piponomics article on how risk aversion led to the unwinding of carry trade.
This is the polar opposite of carry trade. This inflow of capital towards safe assets causes currencies with low interest to appreciate against those with high interest.
In the forex market, currencies are traded in pairs (for example, if you buy USD/CHF, you are actually buying the U.S. dollar and selling Swiss francs at the same time).
You pay interest on the currency position you SELL and collect interest on the currency position you BUY.What makes the carry trade special in the spot forex market is that interest payments happen every trading day based on your position.
Technically, all positions are closed at the end of the day in the spot forex market. You just don’t see it happen if you hold a position to the next day.
Brokers close and reopen your position, and then they debit/credit you the overnight interest rate differential between the two currencies.
This is the cost of “carrying” (also known as “rolling over“) a position to the next day.The amount of leverage available from forex brokers have made the carry trade very popular in the forex market.
Most forex trading is margin based, meaning you only have to put up a small amount of the position and your broker will put up the rest. Many brokers ask as little as 1% or 2% of a position.
Currency Carry Trade Example
Let’s take a look at a generic example to show how awesome this can be.
For this example, we’ll take a look at Joe the Newbie Forex Trader.
It’s Joe’s birthday and his grandparents, being the sweet and generous people they are, give him $10,000. Schweeeet!
Instead of going out and blowing his birthday present on video games and posters of bubble gum pop stars, he decides to save it for a rainy day.
Joe goes to the local bank to open up a savings account and the bank manager tells him, “Joe, your savings account will pay 1% a year on your account balance. Isn’t that fantastic?”Joe pauses and thinks to himself, “At 1%, my $10,000 will earn me $100 in a year.”
“Man, that sucks!”
Joe, being the smart guy he is, has been studying BabyPips.com’s School of Pipsology and knows of a better way to invest his money.
So, Joe kindly responds to the bank manager, “Thank you sir, but I think I’ll invest my money somewhere else.”
Joe has been demo trading several systems (including the carry trade) for over a year, so he has a pretty good understanding of how forex trading works.
He opens up a real account, deposits his $10,000 birthday gift, and puts his plan into action.
Joe finds a currency pair whose interest rate differential is +5% a year and he purchases $100,000 worth of that pair.Since his broker only requires a 1% deposit of the position, they hold $1,000 in margin (100:1 leverage).
So, Joe now controls $100,000 worth of a currency pair that is receiving 5% a year in interest.
What will happen to Joe’s account if he does nothing for a year?
Well, here are 3 possibilities. Let’s take a look at each one:
Currency position loses value. The currency pair Joe buys drops like a rock in value. If the loss brings the account down to the amount set aside for margin, then the position is closed and all that’s left in the account is the margin – $1000.
The pair ends up at the same exchange rate at the end of the year. In this case, Joe did not gain or lose any value on his position, but he collected a 5% interest in the $100,000 position. That means on interest alone, Joe made $5,000 off of his $10,000 account. That’s a 50% gain! Sweet!
Currency position gains value. Joe’s pair shoots up like a rocket! So, not only does Joe collect at least $5,000 in interest on his position, but he also takes home any gains! That would be a nice present to himself for his next birthday!
Because of 100:1 leverage, Joe has the potential to earn around 50% a year from his initial $10,000.
Here is an example of a currency pair that offers a 4.40% differential rate based on interest rates in September 2010:
If you buy AUD/JPY and held it for a year, you earn a “positive carry” of +4.40%.
Of course, if you sell AUD/JPY, it works the opposite way:
If you sold AUD/JPY and held it for a year, you would earn a “negative carry” of -4.40%.
Again, this is a generic example of how the carry trade works.
Any questions on the concept? No? We knew you could catch on quick!
Now it’s time to move on to the most important part of this lesson: Carry Trade Risk.
Did you know there is a trading strategy that can make money if price stayed exactly the same for long periods of time?
Well, there is and it’s one the most popular ways of making money by many of the biggest and baddest money manager mamajamas in the financial universe!
It’s called the “Carry Trade“.
“I’m tired of carrying this!”
What is a Carry Trade?
A carry trade involves borrowing or selling a financial instrument with a low interest rate, then using it to purchase a financial instrument with a higher interest rate.While you are paying the low interest rate on the financial instrument you borrowed/sold, you are collecting higher interest on the financial instrument you purchased.
So your profit is the money you collect from the interest rate differential.
Carry Trade Example:
Let’s say you go to a bank and borrow $10,000.
Their lending fee is 1% of the $10,000 every year.
With that borrowed money, you turn around and purchase a $10,000 bond that pays 5% a year.
What’s your profit?
Anyone?
You got it! It’s 4% a year! The difference between interest rates!By now you’re probably thinking, “That doesn’t sound as exciting or profitable as catching swings in the market.”
However, when you apply it to the spot forex market, with its higher leverage and daily interest payments, sitting back and watching your account grow daily can get pretty sexy.
To give you an idea, a 3% interest rate differential becomes 60% annual interest a year on an account that is 20 times leveraged!
Leveraged Carry Trade Example:
Let’s say you borrow $1,000,000 at an interest rate of 1%.
The bank won’t just lend a million bucks to anybody though. It requires cash collateral from you: $10,000.
You’ll get it back once you pay back the money.
Your loan is approved so fill up your backpack with cash.
Then you turn around, walk across the street to another bank and deposit the $1,000,000 in a savings account that pays 5% a year.
A year passes. What’s your profit?
You earned $50,000 in interest from the bond ($1,000,000 * .05).
You paid $10,000 in interest ($1,000,000 * .01).
So your net profit is $40,000.
With a measly $10,000, you earned $40,000!
That’s a 400% return!In this section, we will discuss how carry trades work, when they will work, and when they will NOT work.
We will also tackle risk aversion (WTH is that?!?
Don’t worry, like we said, we’ll be talking more about it later).
What if there was a way to make money quickly even if you had no idea whether the market would move up or down?
It’s possible as long as there is sufficient price volatility.
And when can you get this volatility? When news like economic data or central bank announcements is released!The first thing to consider is which news reports to trade.
Earlier, we discussed the biggest moving news releases.
Ideally, you would want to only trade those reports because there is a high probability the market will make a big move after their release.
The next thing you should do is take a look at the range at least 20 minutes before the actual news release.The high of that range will be your upper breakout point, and the low of that range will be your lower breakout point.
Note that the smaller the range is the more likely it is you will see a big move from the news report.
The breakout points will be your entry levels.
This is where you want to set your orders. Your stops should be placed approximately 20 pips below and above the breakout points, and your initial targets should be about the same as the range of the breakout levels.
Straddle Trade
This is known as a straddle trade.
You are looking to play BOTH sides of the trades.
It doesn’t matter which direction the price moves, the straddle strategy will have you positioned to take advantage of it.
Now that you’re prepared to enter the market in either direction, all you have to do is wait for the news to come out.
Sometimes you may get triggered in one direction only to find that you get stopped out because the price quickly reverses in the other direction.
However, your other entry will get triggered and if that trade wins, you should recoup your initial losses and come out with a small profit.
A best-case scenario would be that only one of your trades gets triggered and the price continues to move in your favor so that you don’t incur any losses.
Either way, if done correctly you should still end up positive for the day.One thing that makes a non-directional bias approach attractive is that it eliminates any emotions.
You just want to profit when the move happens.
This allows you to take advantage of more trading opportunities because you will be triggered either way.
As most news events tend to have a limited impact on longer-term price action, setting realistic profit targets should help to increase the number of winning trades.
There are many more strategies for trading the news, but the concepts mentioned in this lesson should always be part of your routine whenever you are working out an approach to taking advantage of news report movements.
Let’s now see how to trade the news with a directional bias in a trading scenario.
Let’s go back to our example of the U.S. unemployment rate report.
Scenario: If the U.S. Unemployment Report showed improvement, why did USD still weaken?
Earlier, we gave examples of what could happen if the unemployment report came in light with expectations, or slightly better.In this scenario, let’s say the unemployment rate showed a surprising DROP.
Which is a good thing since that means more people now have jobs.
But you look at your charts and the dollar is FALLING!
What?!
Isn’t the dollar supposed to rise if the unemployment rate is dropping?There could be a couple reasons why the dollar could still fall even though there are more people with jobs.
Reason #1: Overall Economic Outlook Still Poor
The first reason could be that the long-term and overall trend of the U.S. economy is still in a downward spiral.
Remember that there are several fundamental factors that play into an economy’s strength or weakness.
Although the unemployment rate dropped, it might not be a big enough catalyst for the big traders to start changing their perception of the dollar.
Reason #2: Positive Employment Numbers Are Temporary
Perhaps it’s right after Thanksgiving during the holiday rush. During this time, many companies normally hire seasonal employees to keep up with the influx of Christmas shoppers.
This increase in jobs may cause a short term drop in the unemployment rate, but it’s not at all indicative of the long-term outlook for the U.S. economy.
A better way to get a more accurate measure of the unemployment situation would be to look at the number from last year and compare it to this year. This would allow you to see if the job market actually improved or not.
The important thing to remember is to always take a step back and look at the overall picture before making any quick decisions.
Now that you have that information in your head, it’s time to see how we can trade the news with a directional bias.
How to Trade the News With a Directional Bias
Let’s stick with our unemployment rate example to keep it simple.
The first thing you would want to do before the report comes out is to take a look at the trend of the unemployment rate to see if it has been increasing or decreasing.
By looking at what has been happening in the past, you can prepare yourself for what might happen in the future.Imagine that the unemployment rate has been steadily increasing.
Six months ago it was at 1% and last month it topped out at 3%.
You could now say with some confidence that jobs are decreasing and that there is a good possibility the unemployment rate will continue to rise.
Since you are expecting the unemployment rate to rise, you can now start preparing to go short on the dollar.
This is your directional bias.
Particularly, you feel like you could short USD/JPY.
Just before the unemployment rate is about to be announced, you could look at the price movement of USD/JPY at least 20 minutes prior and find the range of movement.
Take note of the high and low that is made. This will become your breakout points.
The smaller the range, the larger the tendency there is for a volatile move!
Since you have a bearish outlook on the dollar (your directional bias), you would pay particular attention to the lower breakout point of that range.
You are expecting the dollar to drop, so a reasonable strategy would be to set an entry point a few pips below that level.
You could then set a stop just at the upper breakout point and set your limit for the same amount of pips as the breakout point range.
One of two things could happen at this point.
If the unemployment rate drops then the dollar could rise. This would cause USD/JPY to rise and your trade would most likely not trigger. No harm no foul!
Or if the news is as you expected and the unemployment rate rises, the dollar could drop (assuming the entire fundamental outlook on the dollar is already bearish).
This is good for you because you already set up a trade that was bearish on the dollar and now all you have to do is watch your trade unfold.
Later on, you see that your target gets hit. You just grabbed yourself a handful of pips! Booyeah!
The key to having a directional bias is that you must truly understand the concepts behind the news report that you plan to trade.
If you don’t understand what effect it can have on particular currencies, then you might get caught up in some bad setups.
Before developing a ‘Trade the News” strategy, we have to look at which news events are even worth trading.
You want to be able to answer, “Which news releases should I trade?”
Forex traders should familiarize themselves with the key event risks that heavily impact the major currencies.
Remember that we are trading the news because of its ability to increase volatility in the short-term, so naturally, we would like to only trade news that has the best market-moving potential for the currency market.
The news that tends to drive price action and produce volatility usually involves:
Changes in central bank policy (“monetary policy”)
Shifts in government policy (“fiscal policy“)
Unexpected results in economic data releases
Random tweets from a certain world leader who likes to put his name on tall buildings
Being aware of upcoming key event risks can help avoid being on the wrong side of the market.
How to Find Events that Produce Volatility
The Economic Calendar highlights the important events and economic data that are being released by the countries with the most popularly traded currencies.
The number of events scheduled can reach over a hundred on any given week! Trying to sift through so many events can be a pain in the butt.
Luckily for you, our Economic Calendar makes it easy to identify the relative importance of each specific event.
In our Economic Calendar, you have the ability to filter event listings by “Impact“.
For example, by selecting only “HIGH“, the Economic Calendar will only display the events that have historically been known to produce market volatility.
If you spend some time exploring the Economic Calendar, you’ll start to notice that the most important events usually relate to changes in interest rates, inflation, and economic growth, like retail sales, manufacturing, and consumer sentiment.
Here are some examples:
Interest rate decisions by central banks
Inflation (CPI, PCE, PPI)
Employment data (unemployment, wage growth)
Economic growth (GDP)
Retail sales
Industrial production
Business sentiment surveys
Manufacturing sector surveys
Consumer confidence surveys
Housing data (sales, construction)
Trade balance
Different countries may use different names for similar data but we try to point that out in the Economic Calendar.
Depending on what’s currently happening in the world, the relative importance of this event may change.
For example, interest rate decisions may be the main focus during a certain time, while during a different time, it will seem like nobody cares.
This is why it’s important to stay informed and know what the market is focusing on at the moment.
Pay Special Attention to News from the U.S.
While the markets react to most economic news from various countries, the biggest movers and most watched news come from the U.S.
The United States is still considered the world’s most powerful country, whether it’s in the domain of military affairs, geopolitics, industry, energy, science, culture, and technology.
It is even described as a “financial superpower.”
Even if its position has been eroded by setbacks, imbalances, and weaknesses, the strength and influence of the US dollar will not be matched anytime soon.
The United States still has the largest economy in the world and the U.S. dollar is the world’s reserve currency.This means that the U.S. dollar is a participant in about 90% of all forex transactions, which makes U.S. news and data important to watch.
With that said, let’s take a look at some of the most volatile news for the U.S.
In addition to inflation reports and central bank speeches, you should also pay attention to geopolitical news such as
Pandemics
Wars
Natural disasters
Political unrest and protests
Upcoming elections
Although these may not have as big an impact as the other news, it’s still worth paying attention to them.
When our economic nerd, Forex Gump, is in a good mood, he usually releases an article on upcoming news reports that you can play and with trade strategies to boot!
Also, keep an eye on moves in the stock market. Especially the U.S. stock market.
There are times where sentiment in the equity markets will be the precursor to major moves in the currency market.
Now that we know which news events make the most moves, our next step is to determine which currency pairs are worth trading.
How to Choose Currency Pairs to Trade the News
After identifying the event to monitor, you now want to trade the currency associated with that event’s economy.
Choosing the appropriate currency pair is an important decision when “Trading the News”.
As a news trader, you are trying to achieve two things:
Take advantage of the short-term spike in volatility…
While keeping your transaction costs as low as possible
Because news can bring increased volatility in the forex market (and more trading opportunities), it is important that we trade currencies that are deeply liquid.
Currencies with deep liquidity have the tightest spreads which is what allows you to keep your transaction costs low.
Liquid currency pairs give us a reassurance that our orders will be executed smoothly and without any “hiccups”.
EUR/USD
GBP/USD
USD/JPY
USD/CHF
USD/CAD
AUD/USD
Did you notice anything here?
That’s right! These are all major currency pairs!Remember, because they have the most liquidity, majors pairs usually have the tightest spreads.
Since spreads widen when news reports come out, it makes sense to stick with those pairs that have the tightest spreads, to begin with.
Now that we know which news events and currency pairs to trade, let’s take a look at some approaches to trading the news.
As forex traders, it’s important to pay attention to major economic data releases, speeches from government officials, and geopolitical events.
Why?
Because this information usually reflects the strength of a given economy and may indicate the future direction of a given currency.
Trading the news is often difficult and not be suitable for everyone, but the volatility that follows can create lots of trading opportunities.
Why trade the news?
The simple answer to that question is “To make more money!”
But in all seriousness, as we learned in the previous lesson, the news is a very important part of the forex market because news has the potential to make the market move!
When news comes out, especially important news that everyone is watching, you can almost expect to see some major movement.
The fact that you know the market will most likely move somewhere makes it an opportunity definitely worth looking at.
Your goal then, as a news trader, is to get on the correct side of the move.
The Dangers of Trading the News
As with any trading strategy, there are always possible dangers that you should be aware of.
Here are some of those dangers:
Spreads Widen
Because the forex market is very volatile during important news events, many forex brokers WIDEN the spread during these times.
This increases trading costs and could hurt your bottom line.
You could also get “locked out” which means that your trade could be executed at the right time but may not show up in your trading platform for a few minutes.This is bad for you because you won’t be able to make any adjustments if the trade moves against you!
Imagine thinking you didn’t get triggered, so you try to enter at the market price… only to realize that your original order got triggered!
You’d be risking TWICE as much now!
Price Slippage
You could also experience SLIPPAGE.
Slippage occurs when you wish to enter the market at a certain price, but due to the extreme volatility during these events, you actually get filled at a far DIFFERENT price.
Big market moves made by news events often don’t move in one direction.
Often times the market may start off flying in one direction, only to be whipsawed back in the other direction.Trying to find the right direction can sometimes be a headache!
Profitable as it may be, trading the news isn’t as easy as beating some toddler at Fornite. It will take tons of practice, practice and you guessed it… more practice!
Most importantly, you must ALWAYS have a plan in place.
In the following lessons, we’ll give you some tips on how to safely trade the news.
