Carry Trade Strategy in Forex (Complete Guide)

Following the introduction of currency rate swings by the Jamaican system, the Carry Trade strategy was developed in the 1980s. Essentially, this trading strategy consists of purchasing the currency of a low-interest country and using the proceeds to invest in assets that yield a greater rate of return, such as equities, currencies with high carry interest rates, etc.

You will understand the Carry Trade technique and its benefits after reading this article. Discover how to minimize the risks associated with this trading method while using it to generate money on the foreign exchange market.

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What is Carry Trade? 

Transport To put it simply, trade is the process by which someone borrows a cheap resource to pay for an expensive one. The interest difference between the loan payment and the yield of the costly resource represents their trading gains.

Carry trade example: The S&P 500 yields a 30% annual return. You invest in futures and receive 20% of net trading gains by taking out a bank loan at a rate of 10% annually. Naturally, the 30% steady yield that the index has produced over the last three years is not a guarantee for the future. You will lose money if the index yields less than 10% at the end of the year.

You have the option to invest in a less hazardous asset with a guaranteed return as an alternative to the S&P 500 index. Government bonds are a popular choice among investors for these uses. However, individual country bonds only yield a 2-3% rate of return, therefore the investor must look for the least expensive loan option.

A few things determine how successful the carry trade technique is:

• Rate of loan. The return on the item that will be purchased with the borrowed funds should increase in proportion to its value.
• Carry trade profitability. It ought to be sufficient to pay for the loan’s expenses as well as transaction support. For bonds, for instance, the yield may be set or it may be floating, increasing in proportion to the stock quote’s purchase price.
• The asset’s volatility for investing. High risk equates to high profit. An investor may therefore experience both a loss and extra interest earnings during periods of extreme volatility. In order to promptly sell quotes in the event of a price reversal, they must continuously monitor market sentiment if they select volatile assets.

Main Components of Carry Trade

The main components of gaining interest earnings with the Carry Trade strategy:

• Central bank key carry interest rate. The rate of lending by central banks to commercial banks is this. They then determine interest rates for loans and deposits. The worth of money is reflected in the discount rate. The trader’s profit or loss, with the rate left intact, represents the difference in interest rates between them.
• Shift in exchange rates. In addition to the difference in discount rates, the investor makes money if it increases.

Opening a sell position in a currency with a low interest rate and a purchase position in a currency with a higher interest rate is the aim of carry trading in the Forex currency trading market. Let’s look at a carry trade example using the Japanese yen. Because it has a low interest rate, JPY has historically been a common example of a financing currency in carry trades. For example, a trader purchases the Australian dollar for borrowed funds in the Japanese yen while initiating a long position in the AUDJPY pair. The JPY key interest rate needs to be lower than the AUD rate in order to profit from the yen carry trade.

Positive Carry Trade

Using the difference in discount rates as a profit center, one method is positive carry trading. An investor purchases a currency with a greater interest discount rate by borrowing money from the nation with low interest rates. They profit from the difference between them at the conclusion of a predetermined period. Currency pairings with a positive long or short swap are suitable for carry trades. A positive swap on foreign exchange indicates that the trader’s balance is credited with the profit at the conclusion of the trading session.

Negative Carry Trade

Negative Carry Trade is when the expense of possessing an asset exceeds its yield, trade occurs. This implies that investments are not lucrative as long as their fundamental worth declines or stays the same. A negative swap in Forex trading results in extra expenses. It is automatically charged when an open trade carries over to the following trading session and is not charged if the trade is closed intraday.

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Why Carry Trading is so Popular?

The carry trade’s appeal is overstated in certain ways. There are several causes:

• Low income. Risk-averse private traders deal with sums as small as $1,000 USD. It is feasible to determine the permitted volume per trade and, consequently, the point value based on the risk. With the point value in hand, you can figure out the exchange profit. Considering the risk and the amount of effort invested, this profit is rarely worthwhile.
• Leveraged carry trades’ hazards. An investor’s long-term return on carry trades appears palpable when leveraged, but this is deceptive. It is rare on a lengthy timescale, but in order to earn a profit, the rate should never go below the leveraged carry trade opening level. You must ascertain the point value with the most leverage if the rate declines. and the minimum deposit amount required to prevent a stop-out from closing the trade. Does it make sense to freeze your deposit if you have one in order to facilitate a carry trade? Remember that using leverage always necessitates careful financial planning.
• Limited number of available assets. Relatively few currency pairs have a swap that is positive. Upon balancing the advantages and disadvantages, we find that profiting from fundamental volatility—such as the EURUSD pair—occurs more quickly than concentrating on the cross rate and developing a distinct trading strategy for it on daily timescales.

A approach that works well in conjunction with the primary speculative operations is carry trading. The swap should not be a reason to give up on the approach if it is negative and there is a chance to profit from the rate differential. The extra profit is a plus if the swap is positive.

What are the Risks Involved?

Risks associated with utilizing the Carry Trade technique in forex trading:

• Price moving against the direction of the trade’s opening. When you initiated a long position, the currency pair’s price dropped right away, and a stop out ended the trade. While you lost money on the spread and rate differential, you gained money on the swap.

If the price goes in the trade’s favor and the stop loss is lowered to the breakeven point, the currency risk is eliminated.

• Modification of the discount rates. Central banks use them to help control the rate of inflation. Therefore, discount rates can fluctuate significantly and not necessarily in the trader’s benefit in emerging nations with fragile economies. Financial crises and the status of the world economy, domestic monetary policy to preserve the stability of the national currency, the economic activity of the major participants in the financial market, etc. are a few examples of factors influencing rates and market sentiment.

Constant observation of the fundamental elements influencing the discount rate mitigates the danger.

I advise diversity to reduce risk. For instance, a blend of the pairs with the highest and lowest profitability. The most lucrative pairs have a higher risk that a nation with an investment currency may lower it in an effort to boost the economy, along with a larger interest rate differential. The review “Risk management in trading for experienced and novice traders” has more information on risk management techniques.

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Strategy for Carry Trade in Forex

It only takes a few minutes to find a currency pair with a positive swap; all you have to do is check the trading platform’s characteristics. You still cannot, however, count on making money from this. Allow me to remind you that purchasing an asset for long positions with a positive swap will not be profitable should the rate drop since the positive swap will not cover the difference in quotations. As a result, I advise pursuing these strategies:

Step 1. Choose a currency

Examine the criteria, compare the central banks’ discount rates, and search for a favorable swap. Assume for the moment that you have located a currency pair with a favorable long position swap.

Step 2. Analyzing the news (fundamental analysis)

In order to ensure that the rate in your open position does not reverse in the opposite direction, you must examine the market sentiment and factors (such as monetary policies and financial crises) influencing the rate. Put differently, the flow of quotes need to enable earning on both a positive swap and their difference. It’s also critical to consider the underlying causes.

Step 3. Analyzing the chart (technical analysis) 

In the near term, there is very little variation in the discount rates. Thus, you have the following two choices:

• Leverage is used to quickly increase the position volume.
• Examine the extended pattern.

The trend needs to be moving in the right direction, or at least sideways, for you to profit from a carry trade. With a positive long position swap, the ideal timing is to coincide with the start of an uptrend on the D1-MN timeframe.

The following trend markers can assist you in identifying the start of a long-term trend:

• Moving averages. Every variant of moving averages effectively displays the long-term trend’s direction. See the review “Moving Average: How to Use the EMA Indicator” for more information on them.
• Alligator. Bill Williams created this fundamental indicator for MT4 and MT5, which consists of three moving averages with various periods and shift parameters. A trend is signaled by the moving averages’ simultaneous divergence. See the review “Alligator by Bill Williams” for additional information.
• Impulse. a leading indicator that gives you the ability to gauge how much the price of a financial instrument has changed over a specific time frame. “The Momentum Indicator: A Complete Guide with Charts and Examples” .

In addition to it, you can use confirming oscillators to help identify the moments of trend reversal.

Step 4. Looking for market exit points

The only thing that matters about a positive swap’s profit margin is its direction; the trend’s dynamics have no bearing on it. However, the ideal course of action is to take advantage of the uptrend as much as possible by closing the position at the moment of the reversal if you have previously identified one. In any event, if you place a stop loss at the level of “trade opening point + spread,” the position will close in profit.

Pros and Cons of Currency Carry Trading

Pros

• Hedging Opportunity: May be used to offset trading positions against one another as a risk management strategy.
• Interest Income: One of the main advantages is the daily interest income that traders, particularly those who maintain their positions for a long time, can receive.
• Low Volatility: Carry trades are comparatively less volatile than other forex techniques since high-yielding currencies are typically from stable economies.
• Diversification: The carry trade provides a means of diversifying strategies and sources of return for individual investors as well as portfolio managers.
• Predictability: Central banks usually give ample warning before making changes to interest rates. Carry traders may be able to modify their positions by using this forward information as a heads-up.

Cons

• Interest rate fluctuations can occur overnight as a result of actions made by central banks.
• Leverage Risk: Excessive leverage has the ability to magnify benefits as well as losses.
• Market Sentiment Shifts: Variations in market sentiment can have a significant impact on carry trades.

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Conclusion

The fundamental idea behind a carry trade in trading is the possibility of making money off of the difference in interest rates between two currencies. There are dangers associated with the carry trade-in trading method, notwithstanding the possibility of profit. The risk of losing the money invested is always great. Key components of currency carry trading include knowledge retention and prudent risk management. Entri app provides you with online Forex course which is designed to teach an advanced strategy in the forex market, which can be used to generate consistent profits throughout your trading career.