In our last lesson we began our discussion of the carry trade and how forex traders implement this strategy to take advantage of interest rate differences between different countries. In today's lesson we are going to continue our discussion on the carry trade, with a look at the role that leverage plays, as well as some of the things traders look out for when trading this strategy.
As we saw in yesterday's lesson, if a trader buys the NZD/USD currency pair, then as of this lesson, they will earn $15 per contract held past 5pm NY time on Monday, Tuesday, Thursday, and Friday. As we learned in our lesson on rollover in module two of this course, they will earn 3 days worth of rolls or $45 on Wednesday to take into account Saturday and Sunday when the market is closed. This brings the total interest paid for the 7 days in the week to 7 * 15 = $105. As there are 52 weeks in a year if a trader held this position for an entire year and the rollover rate did not change, they would earn (105 * 52) = $5460 in interest from the rollover portion of the trade.
At the current market rate for NZD/USD as of this lesson of .7687 this is an annual return from just the rollover portion of the trade of $5460/$76,870 = 7.1%. This of course makes the large assumptions for simplicity's sake that the exchange rate and rollover rate will remain the same as they are today for the 1 year period that the trader is in the trade.
Now you may be thinking to yourself at this point, "well Dave I was kind of excited about this whole carry trade thing and was seeing how it was so popular until I see a 7.1% return plus all the caveats. To be honest with you this does not get me too excited and I don't really see why this is all that popular."
As some of you may have already realized however, if we were to utilize some of the leverage that is available to us in the forex market as we learned about in module two of this course, then we might be able to take that 7.1% return and juice it up into something a little more interesting. So with this in mind, lets say I leveraged this position 2 to 1, which most traders I think would agree is still pretty conservative.
This would double the return from the rollover portion of the trade to 14.2%, a return that if generated consistently would out perform the long term average return of the US Stock market. Taking this a bit further, if I increased the leverage to a more aggressive 3 to 1, that would put my return from rollover at 21.3%, and if I upped the leverage to an even more aggressive 4 to 1 that would put me at 28.4%, a return that if I consistently generated year after year, would put me among the top traders in the world.
When people first see this many times their initial reaction is one of excitement, which makes them want to jump right into a trade. As with most things however, if making money was this easy then everyone would be a millionaire, so while this is an enticing return, and while there has been a lot of money made by people employing carry trade strategies, there are other things to consider:
1. Exchange Rate Fluctuations which can cause additional profits or wipe out all profits and cause losses on the trade.
2. Changes in Interest Rates which can increase the positive rollover, decrease it, or cause a trader to end up paying for holding the position instead of earning.
3. The Use of Leverage amplifies any gains made on the strategy but also amplifies any loss should the trade begin to work against the trader.
It is how traders deal with these unknowns that separates traders who consistently make money with carry trade strategies from those who do not, a topic which we will discuss in our next lesson.
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Risk Disclosure: Trading forex on margin carries a high level of risk, and may not be suitable for all investors. The high degree of leverage can work against you as well as for you. Before deciding to invest in foreign exchange you should carefully consider your investment objectives, level of experience, and risk appetite. The possibility exists that you could sustain a loss of some or all of your initial investment and therefore you should not invest money that you cannot afford to lose. You should be aware of all the risks associated with foreign exchange trading, and seek advice from an independent financial advisor if you have any doubts.