Carry Trades

Most traders are familiar with CFDs, the concept of paying interest on long positions, and receiving interest on short positions. What many people don’t know is that there is also an interest component to be looked at when trading in currencies.

In futures contracts traded on the Chicago Mercantile Exchange, this interest component is factored into the price of the contract, so you won’t see the interest coming into or out of your account.

However, in FX trading, interest is calculated daily on positions held overnight, and adjusted daily on your trading statements.

This article will focus on the FX market, where you are trading the performance of one currency against another currency. For example, the code FXADUS in ProfitSource tells us that we are trading the FX market and we are trading the Australian Dollar (AD) against the US Dollar (US).

Currently, the FXADUS price chart shows a value of around 0.9300, meaning 1 Australian Dollar (the first currency listed) buys approximately 0.93 US Dollars, or 93 US cents.

Traders who are long FXADUS will RECEIVE interest on the Australian Dollar at the overnight cash rate, and PAY interest on the US Dollar at the overnight cash rate. Traders who are short FXADUS will PAY interest on the Australian Dollar and RECEIVE interest on the US Dollar. Depending on your broker, these rates will be very close to the Central Bank Rates listed below (rates current as at 15th September, 2010).

To access any of these currency pairs in ProfitSource, simply type FX, followed by the two digit codes for the currencies you wish to analyse. For example, type FXEUJY to analyse the Euro against the Japanese Yen. The price scale you see will represent the value of 1 Euro buying “x” Japanese Yen.

Let’s go back to the first example, the Australian Dollar against the US Dollar (FXADUS). If we took a LONG position in the Australian Dollar against the US Dollar, we would receive interest on our position at 4.50%, and pay interest on the position at 0.25%, meaning we would receive net interest of 4.25% (4.50 – 0.25) on our position.

Let’s assume we were long the Australian Dollar against the US Dollar with a $100,000 position, meaning each “point” would be worth $US10.

If we held the position for one night, we would receive approximately $11.64 in interest. ($100,000 x 0.0425/365). This is equal to just over one point per day profit in our favour, just for being in the trade.

This type of trade is often referred to as a “carry trade”. In recent years, with Japanese Interest rates close to zero, carry trades with the US Dollar, Australian Dollar and New Zealand Dollar were quite popular. These days, if you take a look at the interest rates listed above, it is really only the Australian and New Zealand interest rates that offer attractive yields.

Bear in mind though, that interest received is a SECONDARY reason to take a long trade. You won’t take a trade simply because it is a carry trade, because if it goes against you, the interest payments won’t be enough to offset the trading losses.

Chart 1 below shows a “potential” carry trade gone wrong on the Australian Dollar against the US Dollar.

Chart 1

click to enlarge

The period I have circled indicates a fall of 43 days. If you were holding a $100,000 position during this fall, you would have received approximately $500 worth of interest – not bad for six weeks work and the $1000 margin.

However, the market fell over 1300 points during this time, which would have produced a trading loss of $13,000. Hardly seems worth it for $500 interest, does it?

Having said that, as long as you manage your risk, there is nothing wrong with being patient and only taking currency trades that will be paying you interest. With trading, it helps to have as many things in your favour as possible, and over time as your positions get larger, interest received can be quite a nice addition to your yearly income.

Be prepared!

Mathew Barnes