Understanding Carry Trading Strategy in Forex Trading

Understanding Carry Trading Strategy in Forex Trading

The forex market is on a constant rise, with now over $5 trillion in circulation per day. This continuous growth is undoubtedly a clear indication that traders are making a fortune.

However, it’s not simple to earn in the forex market, especially if you lack proper strategies.

Generally, the market traders rely on buying the currencies low and selling at high prices.

Trading StrategyTypically, there’re several strategies that one can employ to gain profits in the forex. One of the best strategies is Carry trading.

What’s Carry Trading?

Unlike other forex methodologies that rely on the concept of buying low and then selling high, carry trading is a strategy whereby a trader buys currencies with high-interest rates and then funding it with a currency that yields low.

The profit is derived from the difference between the interest rates in that when the differential is high, the benefits will be more significant.

The currencies that are “high yield” and those that are “low-yield” are relative, and it depends on the interest rates.

Most traders use this strategy in that they focus more on those currencies that are likely to appreciate in the future. The appreciation in the value of the currency is what results in capital gains.

However, in this case, it’s profitable only in the long run and hence not ideal for investors in the short-term.

Carry Trading Advantage

When you trade in the direction of the carry interest, the advantage is that, on top of the trading gains, there’re also interest earnings.

Besides, it allows the use of leverage to the maximum to your advantage. When a broker pays the daily interest on the carry trade, it’s usually on the leveraged amount.

Another benefit that carries trade brings is the stronger probability of earning substantial profits than the rest of the forex trading strategies.

Furthermore, the strategy is less risky as the most interest rates don’t substantially fluctuate.

Keys to Carry Trading

The keys to carry trading are ideally simple. One, you just follow the actions of the central banks.

The carry trades usually develop based on the central banks adjusting their interest rates.

When the country tightens the monetary policy while the other is easing, it provides an opportunity for carry trading as well for capital appreciation.

Another key is identifying the right environment. Carry trading is ideal when the markets are relatively calm, and then the investors display a risk appetite.

Carry trades are very much attractive as the markets need not move for an investor to make money.

Therefore, calm and low-volatility environments are perfect for carrying trade opportunities.

So, which currency pairs are the best for Carrying trading?

When searching for the best currency pairs for carrying trading, high differential ratios are what every trader should be looking for.

For instance, AUD/USD, AUD/JPY, NZD/USD, and EUR/JPY are the best currency because they represent staple economies with low-risk currencies.

With consistent economic growth as well as the active central banking intervention, the pairs are the ideal places to find the opportunities for carry trading.

Why It Is Risky

Trading StrategyCarry trading strategy has some fair amount of risk. The currency pairs with the best conditions for this strategy tend to be volatile; hence, conducting carry trade requires a lot of caution.

A loss as a result of the movements can nullify the profits accumulated due to the interest rates’ difference.

Conclusion

Like any trading strategy, carry trading requires proper risk management and caution when making trades.

It’s significant to combine Carry trading with other supportive fundamentals as well as the market sentiment.

When adequately executed, carry trading can substantially add to your overall returns.

Carry trades also tend to be long and directional. Interest rate policies mirror credit cycles. And business cycles typically last 5-10 years. Therefore, this is not a strategy that one would execute as part of a short-term trading orientation, as interest rate adjustments typically occur only once every few months (or years).

Limiting risk should also be accomplished via two main conduits: (1) using only small amounts of leverage (or possibly none at all) and (2) portfolio diversification.

For US-based traders, the Commodity Futures Trading Commission (CFTC) limits leverage available to retail forex traders to 50:1 on major currency pairs and 20:1 for non-major currency pairs.