Forex basket trading, otherwise known as carry trading, relies on obtaining a basket of currencies that when combined provide a solid hedge while producing an income from the carry interest.
Sound complex? It really isn’t.
The Basics of the Basket
To create a forex basket, investors seek out reliable trading pairs that are predictable and offer very little volatility. For all practical purposes, basket traders want nothing to do with high flying currency pairs and would rather a pair sit and do nothing than rise and fall quickly.
One common combination in a basket is the AUDUSD and the NZDUSD. The Australian Dollar and the New Zealand Dollar tend to range together due to their geographical, economical, and political similarities. However, one currency yields more to hold it than the other costs to borrow it.
During the recent recovery from the 2008 financial crisis, the USD (US Dollar) became the premier currency to short. The USD made excellent carry trade pairs because it:
- Was inexpensive to borrow
- Was from an established, politically sound country
- Wasn’t likely to appreciate, nor lead the world in economic growth.
As such, investors sold the USD against high yielding currencies like the AUD (Australian Dollar.) You can see how this trade played out excellently; as rates were increased in Australia, rates were cut in the United States. Thus, more and more traders piled in, and early-movers enjoyed a cash flowing carry trade combined with rising AUD values:
The AUDUSD's rise after the 2008 financial crisis happened largely as a result of rising rates in Australia and falling rates in the United States
The Process of Basket Trading
Using the AUDUSD and NZDUSD as an example, a trader would long (buy) one currency pair, and sell the other. The hope here is that the two pairs will rise and fall together. So if the AUDUSD that was shorted fell 1% and the NZDUSD that was bought rose 1%, the basket would neither lose nor gain any value.
Making a carry trade basket allows a trader to limit the downside, thus providing a higher, risk-adjusted return. However, as you can see from the chart above, the trader who opted not to create a basket would have higher capital gains on a rise in AUD. They would, though, also have greater risks to the downside, as well as lower cash flow from the carry trade.
Where the Money is
Earlier in this article we mentioned that the profits in forex basket trading come from the carry interest, or the interest that is either paid or earned for borrowing or lending currency. If one shorted currency par, say the AUDUSD costs .5% to borrow, and the other currency pair, the NZDUSD pays 5% to lend, a basket trader would earn 4.5% per year divided by two currency pairs. The effective return on the dollar would be 2.25%.
Unleveraged, 2.25% per year is nothing to write home about. However, with forex brokers offering leverage as high as 400:1 (US-based traders can access these pairs at 30:1, which is still plenty high), there is an incredible amount of money to be made with basket trading. $1000 invested at 20:1 in the example above would generate an annual income of $450 per year. On a $1000 investment that is a 45% return. Of course, that kind of performance would require your basket creates a perfect hedge.
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