Negative Carry in Trading
Negative carry is a situation where holding an investment or trade costs you more than the income it generates.
This concept is important for investors and traders to understand as it can hugely impact their overall returns and portfolio performance.
It’s especially relevant in futures and margin trading, but has various other applications as well.
Key Takeaways – Negative Carry in Trading
- Cost Exceeds Income – Holding the investment/trade costs more than it earns.
- Varies by Market – Occurs in bonds, FX, commodities, futures, and business in general – driven by interest rates, currency differentials, contango, and expenses vs. revenue.
- Strategic Use – Can be employed for potential capital appreciation, hedging, speculation, or other purposes despite the cost.
What is Negative Carry?
Negative carry refers to the condition where the costs associated with maintaining an investment position, such as financing costs, storage fees, interest payments, or other expenses, exceed the income or cash flows generated by that investment.
In essence, you are paying more to hold the investment than what it’s currently earning.
Examples
Here are relevant examples across various asset classes:
Bonds (interest costs exceed coupon yield)
If you purchase a bond with a lower coupon yield than the interest rate you’re paying to finance the investment, you’re in a negative carry situation.
Forex (interest rate differentials)
In currency trading, a negative carry can occur when you borrow a high-interest currency to buy a lower-interest currency.
The interest rate differential works against you, creating a negative carry.
Related: Carry Trading in FX
Commodities (contango and carrying costs)
Commodities futures traders may experience negative carry when the futures prices are in contango (future prices are higher than spot prices), and the costs of carrying the physical commodity exceed the potential gains from rolling over the contracts.
Real estate (mortgage, maintenance costs exceed rental income)
In real estate investing, a negative carry situation can arise when the mortgage payments, property taxes, insurance, and maintenance costs exceed the rental income generated by the property.
Investors will sometimes enter into negative carry deals if they believe the income they generate will raise over time in excess of the costs and/or the capital appreciation will offset it. (There’s also inflation to consider.)
Why Would Traders/Investors Enter Negative Carry Positions?
Potential for Capital Appreciation
Despite the carrying costs, traders/investors might be willing to enter a negative carry position if they believe the asset price will rise significantly enough to offset the negative carry and provide a net profit.
In this case, the potential for capital appreciation outweighs the negative carry cost.
Speculation
For example, in the foreign exchange market, traders often employ negative carry trades as a strategy to speculate on currency movements.
By borrowing a low-interest currency and investing in a higher-interest currency, traders try to profit from the expected appreciation of the higher-yielding currency against the borrowed currency.
Hedging Purposes & Negative Correlation Exposures
Negative carry positions can sometimes be used for hedging purposes within a broader portfolio.
By accepting a negative carry cost on one position, traders may be able to offset or reduce risks in other parts of their portfolio.
They can effectively use the negative carry trade as an insurance policy against potential losses.
Examples
- Entering into put options trades to reduce tail risk
- Shorting stocks
- Having on a negative carry FX trade (long JPY against short Turkish lira) that’s expected to appreciate if other parts of the portfolio decline (risk assets)
Negative Carry for Day Traders
Negative carry impacts day traders as well because of the daily impacts.
Negative carry occurs when the cost of holding a position overnight exceeds any potential gains from that position.
This cost primarily comes from the difference between the interest rates on the currencies involved in a currency pair (in forex trading) or the financing costs associated with leveraged positions (in stocks or other assets).
- Even small negative carry costs can accumulate over time, especially if you frequently hold positions overnight or engage in multiple day trades. This can eat into your profits, making it harder to achieve your financial goals.
- Knowing the carry implications of different currency pairs or assets can influence your trade selection. You might favor trades with positive carry or be more cautious with those carrying a negative cost.
- Negative carry can influence your entry and exit points. For instance, you might choose to close a position before the end of the trading day to avoid overnight financing charges.
- Day traders often use leverage, which involve costs and can amplify both gains and losses.
Tips
- Prioritize trades where the interest rate differential works in your favor.
- Opt for brokers with competitive financing rates and transparent fee structures.
Negative Carry via Contango
Contango futures markets typically have negative carry built-in.
Here’s why:
Contango Defined
Contango is a market situation where the futures price of a commodity is higher than the current spot price.
This often occurs due to costs associated with storing and holding the commodity over time.
Carry Costs
The primary components of negative carry in a contango market are:
- Storage costs – The physical cost of storing the commodity.
- Insurance – The cost of insuring the stored commodity.
- Interest – The opportunity cost of having money tied up in the commodity rather than invested elsewhere.
- Convenience Yield – A more nuanced concept, representing the benefits gained from having the physical commodity readily available versus waiting for a futures contract to expire.
How Negative Carry Works
- In contango, traders expect the price of the commodity to rise over time to compensate for the costs mentioned above.
- The futures price reflects this expected future spot price plus the carry costs.
- Therefore, if the spot price doesn’t rise as expected, the holder of a futures contract can lose money even if the price of the underlying commodity remains flat (due to the built-in carry cost).
Example
Let’s say the spot price of oil is $100 per barrel. The futures contract for delivery in six months is trading at $105 per barrel.
The $5 difference represents the expected carrying costs (storage, insurance, interest) for holding the oil for six months.
If, after six months, the spot price of oil hasn’t increased, the futures contract holder has effectively lost $5 per barrel even though the price of the oil itself didn’t change.
Risks of Negative Carry
Increased Potential for Losses
One of the primary risks associated with negative carry positions is the magnified potential for losses.
If the asset price fails to appreciate as expected, the losses are compounded by the carrying costs incurred during the holding period.
This can result in a more significant erosion of capital than anticipated.
Interest Rate Changes
For certain asset classes, such as bonds or currency trades, changes in interest rates can directly impact the cost of carry.
Rising interest rates can increase the financing costs associated with maintaining a negative carry position, and further erode potential returns or exacerbate losses.
Negative Carry Strategies
Common Negative Carry Strategies
Carry Trades in Forex
In the foreign exchange market, a popular negative carry strategy involves shorting a high-interest currency and buying a lower-interest currency.
The trader tries to profit the appreciation in excess of the negative carry (and inflation rate, since returns need to be measured in purchasing power).
Leveraged Positions Using Options or Margin
Traders may also enter negative carry positions by using leverage, such as purchasing options, contango futures, or trading on margin.
Even with synthetic longs – i.e., buy an ATM call and short an ATM put to replicate the underlying – there is often negative carry because the call’s price often exceeds that of the put for assets with positive expected returns (e.g., stocks).
These strategies can amplify the potential returns but also come with the carrying costs and the standard risks associated with the positions.
How to Avoid Negative Carry
Seeking Assets with Intrinsically Positive Carry
Instead of pursuing negative carry strategies, traders/investors can focus on assets that generate income streams higher than the holding costs.
Examples include high-yield bonds, dividend-paying stocks, rental properties, or other businesses with positive cash flows.
These assets provide a positive carry, reducing the risk of compounding losses.
Focusing on Long-Term Capital Growth
Rather than relying on leverage or negative carry trades, traders/investors may choose to prioritize long-term capital growth.
This approach involves identifying fairly valued or undervalued assets (potentially with strong growth potential) and holding them for extended periods, and allow compounding returns to accumulate over time.
How to Avoid Negative Carry in Futures Markets
Understanding Contango and Backwardation
In the futures markets, the relationship between spot and futures prices helps determine the potential for negative carry.
When futures prices are higher than spot prices, the market is in contango, creating a potential negative carry scenario.
Conversely, when futures prices are lower than spot prices (backwardation), the market offers a positive carry opportunity.
Rolling Futures Contracts at the Right Time
One way to avoid negative carry in futures markets is to carefully time the rollover of expiring contracts to new contracts.
Ideally, traders should aim to roll their positions when the market is in backwardation, as this allows them to capture the positive carry generated by selling the higher-priced near-term contract and buying the lower-priced deferred contract.
Using Spread Trading Strategies
Spread trading strategies, such as calendar spreads or inter-commodity spreads, can be used to reduce or potentially benefit from negative carry situations.
By simultaneously holding long and short positions in different contract months or related commodities, traders can potentially offset the negative carry costs associated with one leg of the trade.
Focusing on Commodities with Natural Backwardation
Certain contracts, like Treasury bonds, tend to have natural backwardation due to the futures contract not having a coupon payment (causing more distant contracts to be priced lower).
By focusing on these, traders may have a higher likelihood of encountering positive carry opportunities compared to markets that are more prone to contango.
Considering Alternative Asset Classes
If the negative carry in a particular futures market becomes too costly or the risks outweigh the potential rewards, traders may choose to explore alternative asset classes.
Diversifying into other markets, such as stocks, bonds, or currencies, can provide opportunities for positive carry or different risk-reward profiles.
Note that while negative carry can be reduced or avoided in futures markets through strategic positioning, it’s often an inherent characteristic of certain markets or market conditions.
Practical Considerations
Identifying Negative Carry Situations
Identifying negative carry situations requires an analysis of various market factors.
In the forex market, monitoring interest rate differentials between currencies is important.
For commodities, tracking the futures curve and contango/backwardation dynamics can reveal potential negative carry scenarios.
For options, compare the net premiums you’re paying relative to the moneyness of the options (e.g., OTM, ATM, ITM).
Risk Assessment and Negative Carry Strategies
Before employing negative carry strategies, conduct a risk assessment.
Traders should carefully evaluate the potential rewards against the carrying costs and consider the impact on their overall portfolio risk profile.
Proper risk management techniques, such as diversification and position sizing, are important.
And note that negative carry is not inherently bad if it serves a specific purpose or provides other benefits.
For example, purchasing put options or shorting securities for hedging purposes may involve negative carry and negative expected value overall, but the cost can be justified by the risk reduction it provides to the overall portfolio.
Conclusion
Negative carry is a situation where the costs associated with holding an investment or trade exceeds the income it generates.
While negative carry positions can amplify potential losses, they’re sometimes used by trader for various reasons, such as speculating on asset price appreciation, currency movements, hedging purposes, or other benefits.
It’s important to remember that negative carry is not inherently negative, but it requires a thoughtful and disciplined approach because it’s often a hidden enemy.
Traders must carefully evaluate the potential rewards against the carrying costs and consider the impact on their overall portfolio risk profile.
Strong understanding of negative carry dynamics, proper risk management techniques, and the ability to identify and calculate the true cost of carry – and the economics of what they’re doing overall – are important for anyone using these strategies so they align their decisions with their overall financial objectives.