Trading Terms

Carry trade: an introduction and guide to carry trading

Skilling Writers Team
2024-04-19
- Trading
- Commodities

Carry trade: A paper displays a graph chart depicting the concept of carry trade.

What is carry trading?

You may be wondering what carry trade is and why it is important enough to read about. Well, it is currently among the most favoured types of investment on the financial markets. How it works is you borrow from a low-interest asset with the intention of using the proceeds to pay for the acquisition of a different asset with a higher interest rate. You profit from the difference in rates by paying a low interest rate on one asset and collecting the higher interest earned by the other asset.

Carry trade investment rationale

FX Carry trades are the source of high positive excess returns over a lengthy period of time. i.e. an equal weighted portfolio of the G10 currencies has returned 6.19% in excess of the 3 month USD deposit rate since 1989

Source: Bloomberg

Similar results are available for emerging market FX carry trades. A simple strategy that went long a basket of high yield emerging market currencies, and went short a basket of low yield developed market currencies has produced returns in excess of 11% since 2005.

Source: Bloomberg

This list represents the universe of countries of which carry trade investors may consider for their trading strategies.

The purpose of carry trades is to compare the interest rates among brokers by utilising data from the trading platform to examine the execution.

Source: Bloomberg

Carry Trade as part of a Global Macro Trading Strategy

One global macro investment approach is where a portfolio manager invests part of his fund in a mix of G10 (development market FX) and emerging market FX passive carry trades, and trades actively gold, commodities and indices in a variety of other strategies with a clear macro rationale.

Many global macro traders employ this type of approach since it includes a core FX carry trade and at the same time encompasses Gold, silver, oil and indices.

The gold macro trader with a flair for FX carry trades most likely is aiming for an investment approach that could position a portfolio to capture big picture global market moves, regardless of the prevailing global economic conditions.

How to carry trade

The way to approach a carry trade is to take advantage of the difference between the interest rate swap of the instrument. This causes the price to lock in profits, while swaps are charged daily. This has the potential to make carry trading profitable due to the difference from daily swap prices.

The benefits of carry trading

You get an edge by placing trades to benefit from ‘carry’ interest since you also earn interest earnings in addition to trading profits.
Using leverage to trade assets you otherwise couldn't afford is another benefit of carry trading. The leveraged amount determines the daily interest paid on the carry trade, which can result in significant gains from a relatively little investment.

Capitalise on volatility in commodity markets

Take a position on moving commodity prices. Never miss an opportunity.

Is carry trading for you?

These factors above make gold carry trading just an excellent choice for those with a strong tolerance for risk. However, it shouldn't be the primary factor in your trading, but rather another thing that offers you an edge.

Tips for a carry trade

The thing to be aware of when trading gold carry trades is that they are not high yielding.
Buy and sell at the same time with the least difference in time to lock in profit and loss.
Wait until the swap price changes before closing the profit, to save the Swap difference obtained.

To find out more about Skilling’s swaps click here.

Factors that affect gold carry trades

Swap changes

The change of the swap price depends on 2 factors: the interest rate of the currency and the fact that the broker may adjust the swap for its own advantage, so there is the risk of not knowing when the broker will make changes which has a significant impact on carry trades with gold.

High spread costs

There is also risk associated with spreads. Some brokers have very high spreads for carry trades, so it may not be worth it because swaps are less than most spreads. Also, only a small number of brokers allow carry trades as there is regulation against this practice.

Risk

What are the risks involved?

Carry trade still involves a high level of risk, especially given the unpredictability of exchange rates. Due to the high levels of leverage used in carry trades, even little changes in exchange rates could result in significant losses if a trader does not properly hedge their position.

More specifically with regards to gold carry trading: first, if the bullion you’ve invested in falls in price steeply, you may incur losses. Second, even if the bullion bank makes a modest gain after accounting for the gold lease rate and price risk hedging, there is still a risk of loss due to currency fluctuations.

Inexperienced people in particular must be wary of this kind of investment advice. Do not be tempted by any ‘risk-free profitability’ of gold carry trades that you may read about. It may be an appealing strategy but there are two main risks involved with it.

Conclusion

If carried out properly, carry trading is a method that might be very successful in the long run. Your exposure to the negative consequences of exchange rate fluctuations can be mitigated by the continuous stream of income it can offer. In order to reduce and manage interest rate risk, you can study various strategies for hedging your bets. Before making a real-money investment, practise your trading on our free demo account.

FAQs

Is gold carry trade profitable?: The gold carry trade is a strategy that involves borrowing gold and exchanging it for risk-free securities. It can be profitable as long as the bear market lasts, since traders repay their leases with cheaper gold in the future.

However, with yields on government debt at unprecedented lows, it is no longer profitable to borrow gold and exchange it for risk free securities. The goal of the gold carry trade is to add supply to the market in order to suppress the price of gold. The profit depends on the course of the exchange rate.
What is the difference between an FX carry trade and a gold carry trade?: Unlike currency carry trade exchange rates which are hugely unpredictable, the interest rate on a gold carry trade is not as swiftly fluctuating. Since a shift in the incorrect direction can rapidly wipe out any profits generated from the interest differential in the carry trade, it is also important to evaluate gold’s current directional trend. This means that even when the trader profits from the interest rate difference, a sizable loss could still be experienced.

The trader receives greater interest rates on the bullion they acquired while paying a low interest rate on the gold they borrowed or sold. The profit is equal to the difference in rates between the two. Carry trading offers an alternative to the difficult daily practice of buying low and selling high.