Learning about carry trades

One of the areas I've been pretty ignorant about in the world of forex is carry trading, which relies on interest rate differentials between currencies to profit from interest rather than fluctuations in the actual currency prices (though those can certainly contribute nicely to any interest gains if they trend in the right direction).

As usual, the Oanda forums proved to be a trove of information on the subject: currently I'm in the midst of this thread, and am finding the posts by Interest-Hawk and the excellently named HAPHAZARD_TRADING particularly interesting.

Interest-Hawk describes the steady profits he's been making with a long position in the GPB/JPY pair, which will pay out just over $22 a day per lot in interest. As he describes his strategy, "I trade using FXCM (a topic for another thread) and they require a 2% margin to earn interest. For me, that comes down to every 100k lot costs me $2000. 2k per lot, simple as that. Each of those lots then pays me exactly $22.70 per day, every day of the year in rollover interest. That breaks down to doubling my initial investment (In interest ONLY) every 88 days."

That got my attention pretty quickly, as did HAPHAZARD_TRADER's list of the currency pairs in his interest-positive basket:

"GBP/CHF, LONG
GBP/JPY, LONG
AUD/JPY, LONG
USD/JPY, LONG
USD/CHF, LONG
EUR/HUF, SHORT, for those who like 100 pip spreads

Not all at once and all the time, but I'll keep trading them so long the INTEREST keeps rollin in."

Carry trading is probably not a great strategy for those who are impatient, short-term in outlook, or addicted to the thrill of freqent trading. That said, I do see an opportunity for a hybrid strategy that combines trading and carrying, with the potential to benefit from both. Here's how I would go about designing it:

Identify a pair like GPB/JPY with a high interest differential

Create a rule-based trading strategy for it as I would for any other pair, but with the exception that...

This strategy would focus only on interest-positive trades: in the case of the GBP/JPY, long trades.

Once I had a working trading strategy that I felt comfortable with, regardless of interest, I'd then start placing long trades with it. If all went well, I'd be gaining interest while hopefully profiting from uptrends in the GBP price as well.

In this type of hybrid system, any losses in trading would be offset by gains in interest, and in the best case, interest and trading gains would coincide to generate significant profits...especially when daily compounding enters the picture.

Another strategy is to open inversely correlated positions that are both interest-positive. This way, any losses in one currency's price would be (roughly) offset by gains in the other, while both earned interest. This is the idea behind a balanced basket of interest-earning currencies.

But I'm still very new the whole carry trade concept, so there's a still a lot to learn. If I've made any amateurish errors here, any carry traders in the audience are welcome to correct them in the comments below.

Related topics:
Carry Trading Strategies
The Economist Covers Carry Trading
Forex Interest Calculator