Here is what you should know about the Carry Trade — how to profit from them, and how to profit when they unwind (often in dramatic fashion) — as a retail trader.
Carry trades occur when there is a large interest rate differential between countries. People buy the higher interest rate currency of the two countries, pushing the price up and collecting the interest rate differential. This can be great, for a time. But it can unwind quickly resulting in very sharp and large price moves. As a forex trader, we need to be aware of both these situations, so we can profit from both the ups and downs.
Carry trades can last years, and can unwind in weeks or months. This is why it is beneficial to know how to trade both sides of it.
The Carry Trade Explained
I originally wrote this article in 2014, and have kept the charts and details from that time, because it provides a great historical perspective. I have added more current details and figures where applicable.
The traditional carry trade—which as day and swing traders we have no real interest in—is when you borrow money in a low-interest rate country and buy an interest bearing asset in a high-interest rate country.
For instance, as of November 2014, the bank rate in Japan is 0.1%, and the bank rate in New Zealand is 3.5%. Theoretically, you could borrow in Japan at 0.1% and then buy a savings bond or some other interest-bearing asset in New Zealand and collect an approximate 3% return. Factor in 4:1 leverage (or greater) and you have a 12% (or greater) return for doing nothing…theoretically.
Reality is a little different. For starters, consumers don’t get the interbank rate on a loan from their bank. We’re also assuming interest rates will stay the same, and we’re assuming that the exchange rate will stay the same. Neither will stay fixed for long, especially the exchange rate.
If the value of the Japanese yen (JPY) rises in this case, it will cost more New Zealand dollars (NZD) to pay it back, thus eating into your profit or causing a loss. On the other hand, if the NZD rises relative to the yen, you have a win-win. You get the interest on your investment (less the interest on your loan) and because you’re holding an appreciating currency it costs less to pay back the loan. You make interest and capital gains.
That is the snapshot of the traditional carry trade played predominantly by banks and major corporations totaling billions of dollars, but generally not individuals.
But, individual traders can play it, quite simply, by taking advantage of the rollover credit they receive from holding a higher-interest currency in their forex account. More on that shortly.
This background is given because there’s a profitable opportunity created by this phenomenon for forex day traders and swing traders.
Since the higher interest rates are attractive to investors/corporations/banks (for the reason discussed above) the high-yielding currency often gets bought up, resulting in an interest gain and capital gain as the higher interest-rate currency appreciates.
The higher-yielding currency involved in these trades is pushed higher, and the low-yielding currency is pushed lower.
It becomes very attractive because as long as people feel they can get out in time, or that the bubble won’t burst, they collect the interest and capital gains. Remember, such transactions are often leveraged and involve billions of dollars when major banks, funds, and investors from around the globe are doing this.
All good things come to an end. Carry trades can be huge, with billions of dollars bet on being able to make an easy profit and get out before it collapses. When that trend turns though, all hell can break loose and all these participants are forced to get out of their positions or face big losses. That means an often sharp and quick reversal of the currency pair’s price as investors clamor for the exits.
What to Watch For in a Carry Trade
Unfortunately, finding a carry trade isn’t as simple as it may appear. Just because a country has a high(er) interest rate than another doesn’t mean there will be a large carry trade taking place.
For instance, in 2014, Japan has the lowest interest, but other currencies such as the USD or CHF also have low interest rates near 0.25% and 0% respectively. Some high interest currencies may have little interest in them, they are not heavily traded, and so they are unlikely to have carry trades. Or they have high interest rates because of uncontrollable inflation and an unstable economy which means people don’t buy the currency despite the high rates. And thus no carry trade.
We’re watching for currency pairs that contain a high-interest country/zone AND a low-interest rate country/zone. And the high-interest country should be a stable one.
I care about carry trades that occur in mixes of the USD, CAD, EUR, GBP, AUD, NZD, CHF, and JPY. Currencies outside these may have them, but these are the big ones to watch.
So as mentioned in the example prior, the NZD/JPY pair, where NZD is 3.5% and JPY is 0.1%, is a prime example. This was a currency pair to watch closely given those market conditions (all rates subject to change). There are also other things going on in the world, and in these pairs, so simply because a high currency pair rises doesn’t mean a carry trade is going on. We’re looking for sustained buying in a high-interest rate currency relative to a low-interest rate currency. That buying can often last years.
In 2021, we can now see how the NZDJPY carry trade played out. Once the carry trade turned lower and NZD interest rates were expected to drop (and later did) the pair fell almost 25% over the next year and half, or more than 2,200 pips.
In 2002 AUD interest rates started to rise and did so until 2008 when we saw the financial meltdown. At that point, rates fell from 7.25% to 3% within a year. But the unwinding of the positions in the carry trade occurred much quicker. When the meltdown hit towards the end of 2008, and AUD interest rates began to drop, it took only 3 months for the previous 8 years of gains to be erased. It was fast, vicious, and enormously profitable for short-term traders who watched this unfold, realized what was happening, and acted on it by shorting the AUD vs. the JPY.
These are trends like any other, except there’s usually much higher volatility as these carry trades unwind.
Interest rates may change periodically throughout the year. Those changes in interest rates have a profound effect on the current carry trades, and could also potentially start brand new carry trades involving other currency pairs. As with all methods in trading, carry trades are dynamic. Watching charts and paying attention to shifts in price trends and interest rates is important.
Other factors also come into play and the carry trade isn’t the only input at work within a currency pair. The important takeaway is that when a carry trade is taking place the reversals are likely to be quick and aggressive, due to the large amount of money at stake.
The crash in 2008 was due to a global issue, yet it’s a great example of the power of the carry trade. There are also a few other things that need to be addressed.
It may be questioned why in a time of panic money flooded into the Yen (chart above) and USD (chart below), both currencies that paid lower interest rates. During times of trouble wouldn’t investors want higher interest to help protect themselves?
The chart below shows the AUD/USD and we can see the sharp selloff of the AUD, or sharp rise in the USD, in mid-2008. The Yen and USD were both weak currencies heading into this meltdown, and the US was vulnerable to the financial crisis. So why did money flow so aggressively into these currencies?
The answer is found in the carry trade. Higher yielding currencies are considered “risk on” trades. Many traders are willing to speculate so they can potentially make the interest gains and capital gains. Low-yielding currencies are considered “risk off” currency trades, meaning if you’re in the low-yielding currency you’re giving up on the potential to make the higher interest rate.
Therefore, when troubles were brewing, and interest rates were in question, traders begin converting back to their lower-yielding currencies forcing a high-yield currency sell-off. They want to be “risk off.”
Basically, there’s a rush for the exits.
As of 2021, over the last 15 years or so, the JPY and CHF have been the risk-off currencies. People tend to flood to them in times of panic. The CHF is a very stable country, which is also why people flood back to it. But it is not used as often in carry trades because people generally don’t like betting against it. But if one does develop, I am very happy to trade it, especially when it unwinds and money floods back into the CHF.
The USD can be either a risk-on or risk-off currency. It depends a bit on where interest rates are and where they are going, and same with the EUR.
In 2020 when the COVID pandemic hit, the EUR had interest rates at 0%. It was risk-off and USD rates were 1.75%. USD was trending up (EUR/USD dropping) until the pandemic hit, and then “Bam”, the EUR skyrocketed against the USD. Anyone who was long the USD (short EURUSD) for the interest needed out, and fast!
The USD dropped rates to 0.25% and now there is basically no interest rate differential and the price comes crashing back down.
After that the countries haven’t touched their interest rates, so the exchange rate is being driven by other factors (and always is).
As a general guide, not necessarily related to the carry trade, in times of panic money flows into the JPY, CHF, and USD from the AUD, NZD, GBP, and CAD. This is often only temporary though, and there may be hard reversals back the other way depending on how long the panic lasts and how long people want to stay in “safe” currencies.
The EUR is a wildcard, and will depend on whether it has higher or lower interest rates. If it has lower rates than most, it will typically act as a safe haven. If its rate is high, money will tend to flow out of it when panic hits.
The carry trade tends to magnify these tendencies.
How to Make Money off the Carry Trade as a Retail Trader
Carry trades have been a factor in many of the major trends which have shaped the forex market in our time, and will continue to play a role in the future. Likely some of your best days and months as a trader will come from the opportunities presented when a carry trade unwinds. Not understanding what’s occurring, and/or fighting it, could mean you have some of your worst trading days or months. This type of unwinding doesn’t happen often, yet when it does, you want to capitalize on it and not be frozen on the sidelines.
In 2021, most major currencies—GBP, USD, CAD, AUD, NZD, JPY, CHF, and EUR—are all sitting at or below 0.5% interest rates. Because of the small difference in rates, I am not considering carry trades right now. I want a larger difference in interest rates, as that attracts buyers into the higher rate currencies, which can cause the moves discussed.
This is not an “active” strategy. Take advantage when it is occurring, and don’t spend any time on it if the conditions aren’t right.
All the information provided so far is to give you a glimpse of the big picture.
For day traders and swing traders, taking advantage of this phenomenon is quite simple, both on the way up and the way down.
Retail forex trading accounts generally give/take from the traders the difference between the prevailing interest rate of the currency pairs they’re holding. This was discussed in “Forex Daily Rollover” in the Forex Intro article.
A trader takes advantage of the higher-yielding currency simply by purchasing it relative to a low-yielding currency. If the Euro interest rate is 1% and the USD rate is 0.25%, by buying the EUR/USD currency pair you’ll be credited with a small amount of interest if you are holding that currency pair at 5 PM EST (a small interest rate differential like this isn’t usually enough to cause a large carry trade).
Since banks/markets are closed on Saturday and Sunday, the interest for these days is made up on Wednesday. Positions held on Wednesday at 5 PM EST are subject to the extra days of interest credits or debits (three days total).
Alternatively, if a person is short the EUR/USD (assuming prior mentioned interest rates) they’ll be debited a small amount of interest at 5 PM EST for holding that position.
Taking part in the carry trade doesn’t need to be a long-term commitment. Rather, commence with regular day or swing trading activities, and by taking a long position in a high yielding currency relative to a low yielding currency you can capture mini-trends and collect interest.
DON’T ONLY TAKE A TRADE TO MAKE INTEREST. Only take valid trade triggers based on a sound strategy. If you can take trades in a pair that’s trending, and collect interest as well, that’s a bonus you should capitalize on.
Leverage in the retail market is often 20 to 100 times the capital in the account. If you can capture a 1% return from interest a year and you’re leveraged at 50:1, effectively you’ll make a 50% yearly return. Combine this with being aware of the major trends in these pairs and you can create a very profitable strategy.
At no point do you want to try to capture the interest rate differential but lose on capital gains. Your ultimate goal is always to be on the right side of the actual trade and trend. The interest is only a “sweetener” for a trade, not the reason for it. Price moves typically dwarf returns made on interest.
Capital gains are your first goal. Capturing some interest may be a secondary goal. When that trend begins to break, forget about interest. As you can see from the chart examples above, when a carry trade breaks you can profit handsomely from the capital gains by trading the reversal, so don’t even think about trying to capture the interest.
Always trade with the trend. Realize a large group of traders are caught on the carry trade, seeking small interest payments, yet will eventually be forced out by large capital losses. The biggest money comes when a high-yielding currency breaks to the downside, as the carry trade unwinds.
The purpose of this article is to provide a potential secondary income in your trading from interest, in addition to capital gains. Realize this is a popular strategy—and when things are popular there’s even bigger money to be made when they go out of style and the carry trade breaks.
When the carry trade does break, you’ll be shorting the higher interest rate currency, which means you’ll be debited the interest rate for holding that short position overnight. Depending on the interest rate differential, the debit could be significant. Plan your trades with this in mind. Try to capture explosive moves that allow you to collect your profit before 5PM EST. If you need to hold a short trade for a few days and pay the debit each night that’s fine, just be aware of it. Preferably you don’t want to be holding through pullbacks where you are giving up profit/losing money and you are being debited interest.
Final Word on Carry Trades
This is not a strategy that is going to be happening all the time, but when it does it can reap big rewards in a short amount of time.
Wait for an interest rate differentials of at least 1.5% or more. 2.5% or more is even better. These tend to create big trends. Stay focused on major currencies. Exotic currencies can have high interest rates, but this is often due to unstable economies which aren’t conducive for attracting the buying interest needed for a carry trade.
Don’t get suckered in by interest rates alone. While the carry trade is going on you want the trend in your direction and collect the interest. When the trend turns, focus on the trend direction and capitalize on the sharp price moves.
Expecting a carry trade to unwind, but there are no big movements? Then it isn’t unwinding yet, there was no carry trade to begin with, or you are too early (or too late if the big moves already happened).
What are the best carry trade pairs for 2021 and 2022?
As of 2021 the interest rate differential between major currencies— USD, CAD, AUD, NZD, JPY, GBP, CHF, and EUR—are all quite low. These countries/zones all have interest rates at or below 0.5% (subject to change). With little interest rate differential the prospect of a strong carry trade is minimal, and owning a currency solely to make a small amount of interest is not worth it in current conditions. Instead, focus on trading trends as opposed to the carry trade.
See current interest rates below.
What are the current forex interest rates?
Here are the current interest rates applicable to major currencies.
How much money do you need to trade forex?
To day trade forex, start with at least $100 to trade a micro lot. For swing trading, start with a minimum of $500 to trade a micro lot. To earn an income, in most places in the world, you will need much more capital than this. Yet, these minimums can get you started and trading in a risk-controlled way.
How can I learn how to trade forex?
Check out the Forex Introduction Course if you are just starting out. It contains what you need to know about currency trading.
If you are interested in learning how to day trade effectively, check out the EURUSD Day Trading Course. Videos guide you through what you need to succeed.
By Cory Mitchell
Disclaimer: Nothing in this article is personal investment advice, or advice to buy or sell anything. Trading is risky and can result in substantial losses, even more than deposited if using leverage.