What is Carry Trading? It is considered one of the most popular strategies used in forex trading. This is a very good form of trading as a forex trader sells a currency having lower interest rate and then acquires another currency which produces an interest rate that is now significantly higher.
Carry trades are trades that are done with specific currency pairs with the thought of earning interest in mind. Whenever two currencies are being traded, a fee occurs that has to be paid. Basically that fee exists because there is a difference in interest rates between the two currencies, and that difference has to be addressed in order to balance the difference out in the forex transaction.
If the trader is buying a currency with the higher interest rate, then they can earn credit, which sometimes can be as much as 20% of the total profit of a transaction. This is a carry trade: a longer term trade going at least one full day but typically longer, which results in interest being accrued.
For a long time, carry trading is a fairly popular strategy in trading Japanese yen. This is because Japan's central bank has been giving out low rates. It is noted that in the years between 2000 up to 2006, interest rates have been at a zero level aimed at helping the struggling economy at that time. In turn, this scenario was very lucrative for carry trading. Currently, the rate in Japan has increased to 0.5%. However, this is still a good figure as opposed to other countries with higher interest rates. For instance, New Zealand has the highest central bank rate at 8.25 %, followed by Australia with 6.5%, United Kingdom's 5.75%, United States at 5.25%, Canada's 4.5% and Eurozone's rate following closely to Japan's at 4%.
As we can see, the New Zealand Dollar or NZD is at the highest. Executing a carry trade with New Zealand Dollars and Japanese Yens (JPY) would yield a differnce in interest rate of 7.75%. For instance if a trader buys NZ$10,000 and sells them equally with Japanese Yen, the transaction will make a profit of NZ$775 in a period of over one year. From this profit, some brokers are involved and thus they take a part of this yield. Alternatively, the above scenario produces leverage where many forex brokers trade with exceptionally high amounts.
Carry trading looks lucrative but at the same time, there are risks involved. Like when the trader bought NZD for JPY, there is a risk that looms in pairing both currencies. However, taking into consideration the current values of both currencies since 2007, carry trades performed will earn the trader the differentials in interest rat and the increase of the New Zealand Dollar as opposed to the Japanese Yen. It is important to note that the very nature of Carry trading includes a risk of unwinding. This occurs when many carry trades are closes up putting the money back in to Japan.
Going back to the topic on leverage as it pertains to carry trade, trading can boost up profit levels. For instance, if a trader has a New Zealand Dollar and Japanese Yen carry trade bearing a 4:1 ratio leverage, the profit that will be generated in this type of transaction will be as much as four times the profit form the differentials on the interest rate. This translates to a surplus of 30% in one year. The effect of this however is also four times on the up and down of the movement of currencies. Thus, it is essential to identify the possible risks and also include the rewards before engaging in carry trading.
A number of traders prefer to use Great Britain Pound (GBP)/Japanese Yen (JPY) or EURO (EUR)/Japanese Yen (JPY) as the interest differential using the paring is currently minimal. Many forex brokers pay these differentials on a regular basis, even daily. Using MT4 broker will give you SWAP. This will illustrate positions that are open with regard to the interest income you have. On another note, opening an interest differential with a negative rate will require payment of the interest incurred thereby, producing zero profit for you.
It's best to buy the currency of a growing economy, in which interest rates are rising. Classic target currency examples include the GBP, AUD, and NZD. On the other hand, it's best to sell the currency of a slowing economy, in which interest rates are falling. The ideal set of economic conditions matches one of the aforementioned target currencies against the typical funding currencies such as the CHF or JPY. The carry trade flourishes during periods of economic and political stability. But these conditions don't always exist.
A lot of traders, including commercial banks and billion dollar hedge funds, run into trouble with the carry trade when they over-leverage or concentrate too much capital in a single position.
Making use of the carry trading strategy can be very rewarding if you are to make good use of it. This strategy has to be combined with a very good forex trading system so that it can yield great profits for your investment. You should also note that all strategies come with their own different ways on how you should trade on the market and all have got very high risks. So when ever you are trading you should make sure that you trade with money that you intend to lose and not with money that you are expecting to make your day to day expenses.
There are also other tips that you can apply in order to get the most out of forex carry trading such as identify a pair with a high interest differential, apply technical analysis and create a rule-based trading strategy using longer term time frames, only long the currency bearing the higher interest rate, and keep an eye on the interest rate differential because it can vary over time
A very simple strategy is the moving average cross over, we only go long when the fast EMA crosses the slow SMA from below (up trend) but we do not take trades when the fast EMA crosses the slow SMA from above (down trend) because the carry trade strategy would focus only on interest-positive trades: in the case of the GBP/JPY, long trades.
If the carry trade strategy is followed properly during each and every trade you enter you will certainly achieve great results. The more money you invest is the more profits you will realize and the risks become high as well.
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