Hello and Welcome to the ditto educational series that will provide you with the skills you need to become a forex trader!
Today we are going to be looking at rollover and carry trade so let’s begin with rollover! Rollover is the interest paid or earned for holding a currency spot position overnight. Each currency has an overnight interbank interest rate associated with it, and because we trade forex in pairs, every trade always involves two different currencies and also two different interest rates.
Overnight Rollover refers to the interest charged or applied to your account after 5pm Eastern time. Now we know what the rollover means, lets get into how it works in forex.
HOW DOES FOREX ROLLOVER WORK?
When you open a forex position, that position will earn or pay the difference in interest rates of the two currencies. This is referred to as a forex rollover rate or currency rollover rates.
Your position will earn a credit if the long currency’s interest rate is higher than the short currencies interest rate. Alternatively, the position will pay a debit if the long currency’s interest rate is lower than the short currencies interest rate.
For example, consider a long trade on EUR/NZD and the EUR overnight interest rate is lower than the NZD overnight interest rate you will pay the difference.
You can find the Central Bank rates online by using your search engine to find them.
If you are considering holding trades overnight, it is important that you monitor the roll rates closely. When market environments are behaving normally, FX rollover rates are generally stable. If the interbank market becomes stressed due to increased credit risk, rollover rates may begin to swing drastically from day to day which is not generally desirable.
There are types of strategies that exist and focus on interest rate differentials, such as carry trades, they attempt to take advantage of positive rollover rates by taking a long position in a currency with a high interest rate and shorting the currency with a low interest rate.
These rates are only applied to positions that are held open after 5pm ET, so traders can avoid the risk of paying a negative roll by closing all their positions prior to 5pm eastern time.
Remember fluctuations in interest rates can lead to big changes in rollover rates, so it is worth being vigilant and monitoring the Central Bank Calendar to know when these events are going to occur.
As for weekends or holidays generally there is no rollover on these days but you probably will still get charged interest on those days so that is always worth considering.
A currency carry trade basically put involves lending a low-yielding currency in order to buy a higher yielding currency with the goal in mind to profit from the interest rate differential. Now this is also known as “rollover” and forms an integral part of carry trade strategy. Traders implore this strategy in the hope of making daily interest payments over and above any currency appreciation from the actual trade.
As we previously discussed, A Forex carry trade involves borrowing a currency in a country that has a reasonably low interest rate to fund the purchase of a currency in a country that has a high interest rate. Holding this position overnight, past 5pm eastern time will result in an interest payment being made to the trader based on the “positive carry” of the trade.
We refer to the lower yielding currency as the “funding currency” and the higher yielding currency is referred to as the “target currency”.
As we know Interest rates are set by a country’s central bank in accordance with the mandate of that country’s monetary policy. A trader can then earn interest on a position when they have bought the currency in the pair with the higher interest rate. For example, if the Canadian dollar offers 4% and the Japanese Yen has interest rates set to 0%, traders could look to buy CAD/JPY to take advantage of the 4% net interest rate differential.
When you look to capitalise on the interest rate differential, you will basically be borrowing the Japanese Yen at a much lower rate and receiving the higher interest rate associated with the Canadian dollar. It is unlikely you will get the full 4% as you have to account for your brokers spread cost.
There are two main factors to a forex carry trade and those are changes in interest rates and exchange rate appreciation or depreciation.
The main factor of the carry trade revolves around the interest rate differential between the two traded currencies in the pair. if the exchange rate between the two currencies remains the same, you will profit from the overnight interest payment. The issue that can arise is central banks deem it necessary to alter interest rates over time and this poses a potential risk to the carry trade strategy and needs to be considered.
Secondarily Exchange rate appreciation and depreciation which is the other main factor to consider. A trader looks for the target currency to appreciate during a buy. When this happens the potential for profit for the trader includes the daily interest payment firstly and secondly any unrealised profit from the currency. Of course the trader will only secure a profit by closing the open positions.
We need to consider when the target currency depreciates against the funding currency as the capital depreciation can nullify the positive interest payments earned.
As always and like any strategy when trading forex, currency carry trades comes with a certain degree of risk. we always negotiate this risk with the adoption of proper risk management and seek to properly consider all potential pitfalls prior to entering any trades.
When considering strategy surrounding carry trade we would seek to Filter the trades in the direction of the trend and most seasoned traders would seek to do this. It is always worth remembering carry trade is generally holding positions long term, and therefore, we always want to be making use of markets that exhibit strong trends. This will increase your chances of getting into higher probability trades and traders should first look to confirm the trend by reading the market’s price action and using other technical analysis tools.
In conclusion to today’s lesson fluctuations in interest rates can lead to big changes in rollover rates, so it is worth considering and monitoring the Central Bank Calendar to know when these events are going to occur.
Currency carry trades present us with two avenues to profit through exchange rate and interest rate differential however and as always it is essential to manage our risk as losses can occur when the currency pair moves against us or the interest rate differential narrows.
We should always seek to trade long term trends for a higher probability at success and we should look for entry points in the direction of an uptrend and should protect downside risk by employing risk management strategies.
I hope you have enjoyed our video today ladies and gentleman please sit back and contemplate what you have learnt today and remember contemplation is the key to learning.