Carry trade is a very common and simple strategy in forex trading. It is one of the most popular investments in the financial markets today through which you a trader can easily profit from rate differentials.
What is Carry Trade?
Carry Trade involves borrowing or selling an asset with a low interest rate and investing in another asset with a higher interest rate. Using this strategy, you profit from the interest rates difference by paying a low interest rate on one asset while collecting the higher interest earned by the other asset.
For example, let’s say that you want to invest using a carry trade strategy. So, you borrow $10,000 with a low interest rate of 1% annually and you purchase a bond that pays 5% for the same period. Here, your net profit from this investment will be 4% after subtracting the lending fees (1%) from the return (5%).
- Positive carry trade strategy involves borrowing a currency with a low interest rate and buying a currency with a high interest rate.
- Negative carry trade strategy involves borrowing a high interest currency and buying a low interest currency assuming that the currency with the lower interest rate will appreciate against the currency with the higher interest rate.
Carry Trade in Forex
When it comes to forex trading, a carry trade is buying one currency with higher rates, and funding it by selling another currency with lower rates. While paying a low-interest rate on the sold currency, the trader collects higher interest rates on the currency that has been bought. The interest rate differential between the two currencies is the net profit.
Carry trading gives currency traders an alternative strategy to buying low and selling high on a daily basis. Most forex carry trading involves the Japanese Yen, Swiss Franc, Australian Dollar, and New Zealand Dollar due to the high interest rate spreads involved.
In forex, you pay interest on the currency you sell and collect interest on the currency you buy. But what makes the carry trade more appealing in the forex market is that interest payments happen every trading day based on your position.
Pros and Cons of Forex Carry Trading
In addition to your trading gains, you can profit from rate differentials as well. This type of trading also lets you make use of leverage to trade assets you would not otherwise be able to afford. The daily interest paid on the carry trade can vary based on the leveraged amount, where huge profits can be made from a modest capital.
However, carry trading is a high-risk investment due to the uncertainty in exchange rates. Even the smallest movements in exchange rates could result in big losses if the trader fails to hedge appropriately when using high levels of leverages. That’s why this type of strategy is only a good option for traders with a high-risk appetite.
A carry trade is borrowing a low-interest-rate currency to invest in another high-rate currency. using proper risk management is highly essential in carry trading, like any other trading strategy. Huge profits can be tempting, so being cautious is very crucial. It is better to support your carry trade strategy with fundamental analysis and market sentiment as well. Carry trade works best in stable and predictable market trends.
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