Carry Trading

Carry Trading is where you buy and hold a currency in order to accrue interest payments.

For example, and this and all figures are taken from the Excel file produced at ElectricSavant.com, which in turn takes its figures from Oanda, if you buy 10,000 units of AUD/JPY at 1:50 margin, you get paid interest at 250% p.a.

250%!!

That's if the price of AUD/JPY remained static for that year. If AUD/JPY went higher, you make even more. If AUD/JPY goes lower, you might still make money if the interest payments are more than the amount you lose in terms of pips.

From that Excel file, the top ten are:
AUDJPY, Long: 250%
GBPJPY, Long: 208%
USDJPY, Long: 200%
GBPCHF, Long: 168%
USDCHF, Long: 161%
CADJPY, Long: 153%
EURAUD, Short: 130%
NZDUSD, Long: 122%
EURJPY, Long: 100%
EURGBP, Short: 87%

So I set about finding if there was some kind of fool-proof way to rake in the interest, and hedge against any potential drop in price.

The thing to note is that if you do a perfect hedge - that is you go long 10,000 units of AUD/JPY in one account, and go short 10,000 units of AUD/JPY in another, then you'll be paying your broker interest. Because here's the reverse of the top ten above:
AUDJPY, Short: -286%
GBPJPY, Short: -237%
USDJPY, Short: -239%
GBPCHF, Short: -192%
USDCHF, Short: -195%
CADJPY, Short: -189%
EURAUD, Long: -168%
NZDUSD, Short: -170%
EURJPY, Short: -137%
EURGBP, Long: -119%

The 250% interest from your long AUDJPY trade is wiped out by the -286% interest from your short.

So, what some people do is create a "Carry Basket" - a group of currencies that combined pay a high amount of interest, but the price is as flat as possible. Every day or week or so, the Carry Trader shifts money around so that the ratio of currencies owned remains fairly constant.

One such basket I read about was:
EURCHF, Long: 61%
GBPCHF, Long: 168%
EURGBP, Short: 87%
EURAUD, Short: 130%

(Actually the ratio was to buy 2x EURAUD than the others, but let's keep things simple).

What I did was, using Daily bars back to the start of 2005, worked out for each day how much interest was accrued, and how much money was gained/lost due to the fluctuations in price. Then I added those figures together to see how much money would have been made in a buy and hold strategy.

Note that I did not use compounding. Everyday the same 10,000 units of each was kept.

The end result is quite fantastic - $4500 in profit, when the margin required to buy those 40,000 units (20K in CHF, 10K in GBP, 10K in AUD) at 1:50 was about $1200. As with all these images, click on it to see the full-size version.

The interest received was around $1500. Meaning $3000 came from price movement.

You can see from these charts, that the big moves in profit all come from the big moves of price in our favour (that's the yellow sections):

EURCHF:

GBPCHF:

EURGBP:

EURAUD:

Let's instead start everything at exactly the worst time - 22-June-05. Markets do change personality, and I assume it's going to happen as soon as I place my first trade using a new system that backtested well. The cosmos might want me to succeed, but it also has a sense of humour.

Now the chart is not so good:

While the interest certainly does lessen the impact of the price going in the wrong direction, it doesn't make up for it altogether. It would have been great to earn all that interest, but the only good part about it for more than a year was that without it, you would have been losing more than you were.

If you add compounding to the mix, I'm not sure the results would be much different. Buying 2x more EURAUD than the others didn't change the shape of the chart either.

So what does this mean? What's the conclusion?

I think that for some currencies, the interest is too much to ignore. However I also think that price fluctuations will always outweigh the amount of interest earned. Interest would be the icing on the cake for trades that went well, and take the bite out of trades that don't.

So... if you want to trade long-term in currency and rake in some interest, how about developing a trading system that only trades in the direction that pays out interest, and base that system on Daily or Weekly bars.

Following the normal strategy - you backtest over historical data, taking into consideration the amount of pips earned and the number of days in the trade. More is better for both. Then instead of buying and holding, and adjusting once per week, you just trade your system - place order, set stop loss. Repeat. Simple.

When I read about Carry Trading in forums, I see the words "sell when you make money", "buy more when the price is going down", "dollar-cost average". None of these make sense to me. These tactics assume the price is always going to rebound, so you're buying while it's "cheap". I don't like that kind of assumption.