Forex Trading Basics Tutorial 8 - The Basics of Forex Carry Trades

In this section, there will be an overview to show how to incorporate economic factors into a trading plan.   Economic factors play a key role in the direction over the long term for Currency Pairs.  Also included will be central banking websites and types of economic indicators and an explanation of what their data means.

An Example of a Carry Trade

Forex trading research and data resources are easily found via the World Wide Web with a simple Google search of the country’s currency and the words “central bank”.  A classic trade example would be a carry trade that uses New Zealand dollar and the Swiss franc. Many traders use this pairing because the Swiss franc has had a historically very low interest rate between 0.5 percent and 0.0 percent, while New Zealand’s dollar has a high interest rate relative to the world’s other currencies.

For a trader to get the best value of a carry trade, he or she would go “long” NZD/CHF.  This means the trader is using the buying power of the account to sell off CHF and use the proceeds to buy NZD.  Of course, he would pay interest in the currency he borrowed in (CHF), however he would also be “earning” interest in the currency he was long.   Money is earned on the trade by adding the earning interest and subtracting the charged interest.  The total income for the trade, or net amount, is called the interest rate differential.

Use Central Bank Indicators to See if Interest Rates will Change

Checking the economic indicators of both countries (NZD/CHF) by using the websites at Swiss National Bank http://www.snb.ch/en or the Reserve Bank of New Zealand http://www.rbnz.govt.nz/  .  These websites will offer information on whether the interest rates will be staying the same or changing soon.

A checklist below highlights some of the main economic indicators that traders seek out on central banking websites.  Central bankers also keep an eye on economic indicators as well in order to ensure a smoother economy. They will watch other’s countries patterns to see how they act and Banks like the Swiss National Bank or Reserve Bank of New Zealand will react in kind, raising rates, lowering rates or keeping them unchanged.  The same information that the central bankers use is what Forex market traders use to explore whether a countries’ economy is growing, slowing or showing no change.

Besides these indicators, a time frame is typically offered as to when the next bank meeting will take place, along with any interest rate changes to be announced.  The meetings are usually held on every second or third month.  All professional traders note these upcoming dates and pay sharp attention to the market announcements, as interest rates can quickly change.

 

 

 

While getting the hang of dissecting economic indicators can take years of experience, traders will gain deeper comprehension by learning about the specific economic conditions of the countries with the currencies they prefer to trade most often.

By taking the example previously used, NZD/CHF, and searching the central banks websites, a trader might find the CHF has an interest rate of 0.25 percent while the NZD is at 2.50 percent.  Called the “Cash Rate”, “Discount Rate” or “Overnight Rate” or similar, this simply is the discount rate at which the Central Bank of each country uses to propel their countries’ economies forward.  The long NZD/CHF will have the trader charged 0.25 percent but earn 2.50 percent.  The net interest rate is subtracted from the two (2.50-0.25=2.25 percent).  This is not the “cash balance” on the account, just the “trade balance”.  Moving on in an example of the NZD/CHF carry trade, and if the trader has set his ratio for 50:1 while using 33 percent of available purchase power on the $250USD cash balance.  Using these figures and settings he will earn $250USD x 50 = $12,500 x .33 = $4,125 x 2.25 percent = $92 (non-compounded) on the $250USD cash balance, or the yearly interest rate of 36.8 percent ($92/$250=36.8 percent). In addition to the 36.8% interest rate the trader will also earn any capital gains when the NZD rises in value against the CHF.

Other Advantages to Economic Indicators

Tapping into another well used economic indicator, professional traders realize that if one country’s currency rates are high, they will naturally seek lower interest rates in another currency (and another country).  Essentially, when the world economy is dragging down, stagnating or not growing at anticipated levels, the countries with higher growth and higher interest rates will be hit the hardest.  This is the theory that those countries that are running the highest, strongest economies have the farthest to fall to a weakened economy.  The reverse is also true.  The countries that are the weakest and slowest will get a bigger benefit by having their low interest currencies suddenly in much greater demand.  The slower economies also had less room to fall than the faster, stronger economies.

Worldwide Economic Indicators and the Direction of Carry Trades

Keeping this in mind, analyzing the fundamental indicators for New Zealand’s economy could show that it is growing, while the Swiss economy is slow or possibly recessionary.  Once again, this type of vital information can be found by reviewing the central banking websites for each country.  Traders leverage the economic information to judge whether their selected currency pair will be profitable or not.  Knowing that a better economy means a long Carry trade, a trader will pare down which currencies pairs he wants to utilize to set up a better trade for this particular scenario.  On the opposite side, a weakening economy means a short Carry trade, thus finding currency pairs more suited for this environment.  Always keep in mind that the economic crystal ball does not see very far into the future, and can change on a daily basis thus adding to the up and down movement of a carry trade.

The last tutorial will review the basics of automated trading, what it is and the advantages and disadvantages of automated versus discretionary trading.

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tothetick

Professional team of writers/analysts analyzing the financial markets.

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