Proper use of interest rate information pays rich dividends in Forex trading, and the carry trade is one such example. Carry trading is an old and often practiced foreign exchange trading policy that uses the difference in interest rates between two currencies.
Executing a carry trade and making money in the forex market requires patience, discipline, and a solid understanding of macroeconomic factors. Here’s how carry trading works and what you need to do to get the most out of it.
NOTE: Forex investments involve significant risks. Do not consider the opinions mentioned here to be financial advice. Please research thoroughly before making any investment.
How does the carry trade work in Forex?
In Forex trading, each currency is associated with an interest rate set by its respective central bank. Some countries, such as Japan, traditionally maintain very low interest rates, while others, such as Australia or New Zealand, often have higher rates.
When a trader sells Japanese yen, he or she is actually borrowing Japanese yen at a low interest rate. At the same time, when they buy Australia’s native currency, they are lending money in a currency that earns a higher interest rate. This difference between the two rates is called the interest rate differential.
Getting the most out of carry trading
Knowing the right conditions when carry trading gives the best results. Here are the conditions:
- Global economic conditions stable or improving.
- Low market volatility as gains from the carry trade accumulate slowly on a day-to-day basis. On the other hand, volatility losses accumulate more quickly and any gains made through carry trading can be erased within minutes in a volatile market.
- Risk sentiment among investors seeking yield. In a risk-oriented environment, investors are willing to take risks because they believe market conditions are improving. Investors are willing to bet on yield-seeking opportunities, such as carry trading.
- No rapid changes in central bank policy, as rapid changes in interest rates do not allow small gains from carry trading to accumulate.
- A clear divergence in interest rates between currencies forms the basis of carry trading.
In risk-averse environments, investors rush to safe-haven currencies like the US dollar and Japanese yen, causing carry trades to violently unwind.
Traders should also monitor the swap rates offered by brokers. The prices offered by brokers vary and directly affect profitability. Some brokers reduce or even cancel carry advantages.
Additionally, as with all types of business decisions, risk management is also essential for carry trades. Using stop loss mechanisms helps control damage if carry trades slow down. Additionally, position sizes should not be huge, as losses also magnify when volatility dips or banking decisions take a disadvantageous turn.
Edited by Abu Amjad Khan
