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Carry Trade

Carry trading is one of the simplest currency trading strategies. It involves buying or holding a currency with high interest against a currency with low interest. For each day that you hold that trade, you will receive the interest difference between the two currencies traded from your broker provided you are trading in the interest-positive direction. Today, carry trade is one of the most popular types of investment in the financial markets. 

For example, if the Euro (EUR) has a 6% interest rate and the U.S. dollar (USD) has a 3% interest rate, and you buy EUR/USD, you are making a carry trade. Hence, for every day you hold that trade on the market, your broker will pay you the interest rate difference between the two currencies; in this case 3%. Such an interest rate difference can accumulate over time.

This strategy is not time-consuming and very high profits are possible if you grab the right position opportunity. You need to look at the fluctuations in interest rates over a long period of months or years. Ideally, you should trade a position that has a low, declining interest rate and get a currency that has a high, increasing rate.

How does currency carry trading work

Basically, in carrying trade, a trader borrows a currency (for instance the USD) and uses it to buy another currency (for instance the CAD). While the trader pays a lower interest rate on the sold or borrowed currency, they simultaneously receive higher interest rates on the bought currency. The profit earned is the difference between the interest rates of the two currencies. Carry trading aims at giving forex traders an alternative to the popular “buying low and selling high” method, which is a tough thing to do daily. In forex trading, most carry trades involve the Japanese Yen (JPY) pairs such as the AUD/JPY and NZD/JPY as a result of the high-interest rate spreads involved.

How does FX carry trade work

In forex, a trader makes a profit from the difference in the interest rates of a currency pair as long as the exchange rate does not significantly fluctuate. The currency with the lower interest rate is referred to as the funding currency and it is, therefore, the currency that is being exchanged or traded. Forex traders execute a carry trade by borrowing the funding currency with a low-interest rate thereby taking short positions or selling the asset currencies. The concerned central banks of these funding currencies usually use regulatory monetary policies to lower interest rates in order to enhance growth during the recession, promote lending and inject money into the economy while they increase the rates in order to control inflation. As the interest rates reduce, traders borrow money and invest in short positions. For instance, if an FX trader finds out that the rate of the Japanese yen is 0.4%, while the rate of the Australian dollar is 5%. The trader aims to make a profit of up to 4.6%, which is the difference between the two interest rates. The trader will then enter a forex carry trade by borrowing JPY and converting them into AUD. The trader will thereafter invest the money into security or instrument that pays the AUD rate. The trader will finally reconvert the proceeds made from the investment after making a risk-free profit from the difference between the rates of the two currencies. The trader will even profit more if the exchange rate moves against the yen. However, along the way, if the yen gets stronger, the trader would earn less than the 4.6% interest spread and also lose from their investment.

Pros of currency carry trading

When you open a carry trade with a broker, in addition to the interest earnings acquired, you will also incur trading gains. Even if the trade market or exchange rate is stagnant, you will still make profits from the interest earned.

Cons of currency carry trading

Carry trading is associated with significant risk due to the doubt in exchange rates; hence, it is an option for only those with a high-risk appetite. The best currency pairs for this strategy are volatile; therefore a trader must be very cautious before entering a trade. Without proper risk management, a trader might incur a great loss. The term “carry trade unwind” is a carry trader’s nightmare that causes the funding currency with the lower interest rate to strengthen aggressively. For instance, during a financial crisis, the Japanese yen tends to undergo a “carry trade unwind”

Risk management in carry trading

Carry trading often comes with a fair amount of risk since the best currencies involved sometimes tend to become volatile. Without proper risk management, a trader can find themselves in a brutal turn. Therefore, the best time and most effective way to enter these trades are when market sentiment and fundamentals support them. Carry trades are best traded during positive market sentiment and when investors are in a buying mood. Like other forex trading strategies, a trader should use the proper risk management and use your head when entering trades. A carry trade properly carried out can add considerably to the investor’s overall returns.