Carry trade refers to a strategy where a trader sells currency with low interest rate and at the same time buys a different currency with higher interest rate. The idea behind it is to seize the difference between the rates and make profits, based on the leverage used.
FX carry trade stands as one of the most popular trading strategies in the foreign exchange market. The most popular carry trades involve some widely used currency pairs in the forex market such as the Australian dollar-Japanese yen pair and the New Zealand dollar-Japanese yen pair. The interest rate spreads of the currency pairs are known to be quite high. FX trade follows the principle of “buy low, sell high.”
How Does A Carry Trade Work?
Carry trade could be defined as holding one’s forex trade for a day because one currency has higher rates than another to profit from the interest rate difference between both currencies. It simply means one buys high-interest currency as compared to low-interest currency. Typically, one places the proceeds if the second currency has a better interest rate. The money could be invested in assets with a second currency value, including stocks, bonds, commodities, or real estate.
As long as one holds the trading, one gets the appropriate profit that the brokers calculated on the interest rate difference. However, the payment would only take place if the trading takes place in the direction of an interest-positive trend.
It works simply by borrowing one currency, for example, the US dollar, which has a low-interest rate, and utilizing the number of borrows to buy another currency, the Japanese yen having a high-interest rate. As a result, one gets to pay a lower interest rate on the borrowed currency, i.e., the dollar, while simultaneously collecting a higher interest rate on the other currency yen. Hence, the difference between currency rates, the dollar, and the yen, is that one gets the desired profit.
First you have to figure out the interest rate differential and the forecast for the selected currency pair. Then you basically go long a currency with a high interest rate and short a currency with a low interest rate. Hold the position for a while based on your trading plan to take advantage of the interest rate differential.
The trick is to find a currency pair that will have an exchange rate movement during the carry trade which favors the higher interest rate currency.
Widely held carry trade currency pairs are:
- AUD/JPY
- AUD/USD
- NZD/JPY
- EUR/JPY
KEY TAKEAWAYS
- A currency carry trade is a strategy that involves borrowing from a lower interest rate currency and to fund purchasing a currency that provides a rate.
- A trader using this strategy attempts to capture the difference between the rates, which can be substantial depending on the amount of leverage used.
- The carry trade is one of the most popular trading strategies in the forex market.
- Still, carry trades can be risky since they are often highly leveraged and over-crowded.
- In addition to potentially earning interest, carry traders can recognize profit or loss on the value appreciation or deprecation of the currency pair.
The Risks Involved in Carry Trade
Nothing is for free and, like everything in trading, carry trade may results in substantial loss. What can possibly go wrong? Let’s see…
1. Higher the Leverage = Bigger the Disaster!
High leverage used in carry trade can result in losses if the market moves sharply in the undesirable direction. Your trade is then prone to hit the margin calls or to be automatically closed when the stop/loss is reached.
2. Interest Rate can Shift
In case the interest rate differential broadens – good for you! This is exactly what you are looking for.
On the other hand, if the interest rate differential shrinks down, you will end up with almost no return.
Where to find the carry trade
Carry trading is mostly done using forex products at a spot forex market provider like IG. Daily estimated overnight funding rates for forex can be viewed in the platform under the term swap rates, whereby the swap bid applies to short positions and the swap offer applies to long positions.
Forex carry trading risks are there, however it is simply impossible to ignore the potential profits and chunks of serious cash made in the process! After all, there is no way of making real money without even a slightest pinch of risk involved, don’t you agree?!
