Defining Negative Carry

Are the costs of holding your trades quietly eating away at your profits? 

Negative carry is a crucial concept for traders to understand, especially in stock and options markets. It happens when the expenses of maintaining a position—like borrowing fees or time decay—outweigh the returns. For traders using advanced strategies, these hidden costs can chip away at gains or even magnify losses over time. 

This article will break down what negative carry means, why it matters, and how you can manage it effectively to stay ahead in your trading decisions.

Defining Negative Carry in Trading 

Negative carry in trading refers to a situation where the cost to maintain a position exceeds the return or income earned by that position. This concept is particularly relevant in activities such as stock trading, options, and futures. Returns from the position must exceed those associated with ongoing expense, namely borrowing costs for short selling stocks or premium paid for options held, for it to have the potential to be profitable. A position is said to have a negative carry when the expenses are greater than the returns.

Negative carry in the world of options trading shows up when the premium paid for an option (particularly an out-of-the-money one) erodes over time without sufficient price movement in the underlying asset to offset that decay. It happens because of the time decay factor (aka ‘theta’) whereby the value of an option diminishes progressively as it approaches its expiration date. The reason is that if the underlying asset’s price doesn’t move in the direction you like, then as time passes, the premium you paid erodes, and you don’t get any returns from that.

Stock trading also experiences negative carry, most often in short selling. Borrowing fees and other holding costs will be incurred by a trader when they borrow shares to sell short, so they have to wait for the stock’s price to drop.

These ongoing costs can usually exceed the profits from a short sale if the price does not fall sufficiently, or quickly enough. Negative carry is something that traders need to understand and manage – it can drain your profits slowly, even turning into losses if it is not watched carefully. 

Mechanics of Negative Carry 

A position is said to have a negative carry when the cost of holding it exceeds the income or returns it generates. Negative carry in stock holdings is common when traders short-sell and cover borrowing costs. Borrowing fees, interest costs, and, in some cases, dividend obligations are incurred by traders when they borrow to sell shares to repurchase them at a lower price. But over time these expenses add up, and if the stock price does not fall quickly or enough, these ongoing costs will eat away at the potential profits of the trade, creating a negative carry.

For traders that purchase options, and particularly out-of-the-money options, they pay a premium upfront for the right to buy or sell the underlying asset. Nevertheless, over time the value of the option diminishes, something called ‘theta decay’. This means the longer a trader holds an option without a large price move in the underlying asset, the less value their premium paid for the option has. However, this time decay becomes crucial when you approach the expiration date of the option which raises the risk of the option finishing worthless.

In stocks and options negative carry is the ongoing cost of maintaining a position that does not cover its own costs. Negative carry can eat away at returns over time, so traders need to be very careful when balancing potential profit with the risk that holding a position doesn’t move in the desired direction. In order to manage the risk of negative carry in both stocks and option trading, it is vital to understand how these costs play together under different market conditions. 

Real-World Examples of Negative Carry

Stocks, options, and futures trading often involve negative carry—let’s explore some real-world examples that illustrate its application.

Negative carry is a common occurrence in short selling stock. For example, what if an investor is shorting shares of a company that is currently being called out in the public eye? They pay the borrowing fee while waiting for the price to drop, plus if they are paying dividends to the holder of the share. But should the stock suddenly bounce back, like it did when Snap rolled out AI features in 2023 and the stock price jumped, those costs can eat into profits or exacerbate losses in a hurry.

Negative carry is also a component of options trading, especially deep out-of-the-money options. For instance, a trader wanting to bet on a huge price swing in the price of a tech company such as Nvidia (NVDA) during earnings season will pay a high premium for the option. But when the stock doesn’t move sufficiently, or quickly enough, time decay (theta) eats the value of the option, leaving the trader holding losses. For traders, this has been the scenario during Nvidia’s volatile earnings periods.

Oil traders felt this last year when geopolitical tensions sparked steep storage costs while anticipating OPEC production cuts drove up prices.

This just goes to show how important it is to balance the carrying costs against potential returns. You never know what will happen, and things can turn bad very quickly. 

Strategic Reasons for Accepting Negative Carry 

There are immediate costs to negative carry, but traders may nevertheless use negative carry strategies for strategy reasons. Hedging is a major reason why traders will take negative carry to hedge off portfolios from downside risk. For instance, if we purchase put options to hedge a long stock position, we pay upfront costs such as premiums and time decay. This produces negative carry but it restricts losses in a market downturn. The cost of the hedge is seen as a necessary trade-off to hedge against significant losses, making it a good long-term play.

The other reason is the potential long-term gains. Traders anticipating significant market shifts can accept short term negative carry, in hope of future profits. For instance, in a time of rising interest rates, a trader may still want to hold a short bond even if it means paying borrowings. The bond’s value is expected to decrease significantly and, therefore, more than cover the holding costs, making the project profitable. Negative carry, in this case, is a short-term calculated expense for a more significant payoff.

Furthermore, arbitrage opportunities tend to have a negative carry. Pairs trading or market-neutral approaches, for instance, may gladly accept borrowing fees or time decay to exploit price inefficiencies, as do market-making strategies. For example, a trader could short an overvalued stock and long an undervalued equivalent, soaking up short-term costs in the hope of achieving a larger profit later when the price differential between the two narrows.

Negative carry ultimately brings the bigger picture. Traders care more about risk management, protection of the portfolio, or future rewards than the costs today. With shifting geopolitical dynamics impacting risk-reward ratios, they mitigate short-term expenses in pursuit of long-term rewards by using negative carry as a tool to work towards their financial objectives.

Advantages of Negative Carry Strategies 

Though initially costly, negative carry strategies give traders a unique advantage when they take them on as a portfolio tool. One key benefit is leverage. Traders amplify their exposure to market movement for small initial investments using strategies like short selling or purchasing deep out-of-the-money options in the futures market, for example. These positions create holding costs, but even small changes in the underlying asset can generate outsized profits exceeding those of negative carry expense.

The next advantage is protection against market declines. Negative carry can frequently be found to be used for hedging, for example by buying put options on long positions to ‘protect’ if volatility increases.

Hedging costs may put a slight dent in returns in flat or rising markets, but they protect the downside on dips in the market even a bit if the market moves unfavorably for the trader. In particular, negative carry strategies are highly attractive for investors seeking low risk and stability in the long term, foregoing the short term profits.

Negative carry strategies finally let traders continue holding positions in the face of uncertainty and position for the future gains. For instance, in currency trading, a trader with a bearish view on a high yielding yet negatively spoiled currency could long that currency by shorting it. The costs of keeping the position amount for some time in the future are a necessary trade off in order for it to pay off due to expected future movements in the market.

Essentially, negative carry trade strategies are being made at the risk that short-term losses, whatever they incur, will be offset by leveraged gains, loss mitigation, or long-term profitability. Despite their own front-end challenges, these strategies can help traders achieve their targeted financial objectives by carefully weighing the costs and potential rewards before using them. 

Disadvantages of Negative Carry 

Negative carry has many risks and financial downside risks associated with it that can severely hurt the overall profitability of a trader. The biggest thing is that the ongoing costs associated with being in a negative carry position can eat away at profits over time. If the underlying asset does eventually move in the desired direction, it could still take so long that profits from the move are not sufficient enough to offset the carrying costs that accrue over the course of the trade.

Another major risk is that negative carry can blow out losses much worse in a market that moves against your position. For instance, in a short selling situation, the trader has to deal with the double whammy of greater losses as stock prices rise and the ongoing charge for borrowing.

The same thing happens with options that have negative carry because of time decay, in which an out-of-the-money option can expire worthless and the trader loses all of the premium paid. As the time horizon increases, this risk gets amplified the more so if the expected market movement doesn’t occur quickly.

Further, negative carry strategies demand skilled trade timing, as incorrect timing may translate to higher losses. When the strategy is used in volatile and unpredictable markets, in particular, holding a position for too long without the price movement one expects can result in large capital drain.

Market conditions like changes in interest rates or borrowing costs only increase the negative carry’s burden further and introduce an additional element of randomness to the cost of carry. Especially for traders using leverage in their strategies, this can increase the risk, as both negative carry costs and potential losses will be amplified, possibly resulting in significant drawdowns or even margin calls. 

Managing Negative Carry in Trading 

Strategic planning and disciplined execution are needed to keep ongoing costs of negative carry as small as possible. Timing trades well is an important tactic. Consequently, we are able to enter and exit positions at points where the duration of exposure to negative carry is minimized.

Take options trading as an example, buying or selling options closer to expiration can help reduce time decay. Similarly, short sellers can also reduce the borrowing costs associated with their positions by limiting the holding period of the positions.

Furthermore, there is choosing options with favorable premiums. Lower premiums options are selected because initial costs are kept low and the effects of negative carry are reduced. Traders should also look at time decay (theta) to ensure that expected price movement happens before the premium cost is greater than the potential profits. Balancing price movement potential and cost efficiency can be achieved by choosing options that lie closer to the money, and have a shorter expiration period.

Another critical strategy is adjusting leverage. Leverage can be overlayed on top of profits with good carry and bad carry, amplifying the effects of negative carry. Leverage should align with traders’ risk tolerance and the possibility of favorable trade outcomes in the required timeframe. Position size and leverage may be reduced to limit negative carry exposure. Furthermore, hedging strategies like complimentary trades can hedge against the potential losses and carry costs.

Traders can reduce the financial expense of negative carry by timing trades, picking cost-effective options, watching leverage, and using hedging tactics. Trading alerts can support these efforts by highlighting optimal entry and exit points or changes in market conditions. Practicing these disciplined habits helps balance short-term costs with longer-term financial goals, making negative carry workable in a well-thought-out trading plan. 

Conclusion

In short, negative carry is an essential concept for traders to be aware of when they trade positions that have ongoing costs, including expiring options and strategies that involve short selling. Holding costs can erode profits over time, but traders who know and can forecast these issues can also mitigate the impact. A key to successful trading is understanding when the negative carry is acceptable for long-term gain or risk hedging.

At the end of the day, strategies exist to offset negative carry, like timing trades, choosing favorable options, and resetting leverage, which traders can wield in an effort to offset the price. Traders can avoid the downside of negative carry and the strategic advantages it presents by approaching trades with knowledge of the associated risks and costs. Through thoughtful planning, negative carry can be managed effectively to support long-term trading goals. 

Negative Carry: FAQs

What Trading Scenarios Are Most Susceptible to Negative Carry?

Negative carry often arises when holding costs exceed returns. Short selling is another common example, where one is charged interest on borrowed shares, and options trading is one in which time decay is eating away the premiums. Other scenarios include leveraged positions (leverage), futures contracts, and high-interest debt instruments with large financing costs.

How Can Traders Use Negative Carry to Their Advantage During Market Volatility?

Negative carry strategies can be used by traders as a hedge against volatility. On the other hand, options, where time decay costs exist, provide insurance against sharp price swings. In such volatile markets, gain from large movements could compensate for the holding cost, making negative carry a strategic advantage.

What Role Does Expiration Date Play in Managing Negative Carry in Options Trading?

Time decay increases as expiration approaches, and so expiration dates are crucial. Negative carry is spread out over longer expirations and time decay is intensified for shorter expirations. Measuring expiration dates allows traders to keep an eye for negative carry on their positions.

Can Negative Carry Be Avoided Altogether in Options Trading, or Is It an Inherent Part?

Time decay means inherent negative carry. That can, however, be mitigated by buying in-the-money options, creating spreads to cover costs or if volatility will likely be high, choosing time periods that are shorter. Negative carry can also be turned positive by selling options.

What Are the Best Tools or Indicators to Assess Negative Carry Impact Before Entering a Trade?

Theta measures time decay, while implied volatility measures how much a stock can move to offset negative carry. Risk-reward tools can evaluate the cost of carrying, and interest rate calculators can evaluate financing costs.