FX Carry Trade Strategy
Many traders today use different technical and fundamental trading strategies to make forex trading easy. However, some traders use other methods that are just as profitable as the most popular technical trading strategies. One such trading strategy is the FX carry trade.
The FX carry trade, also referred to as the currency carry trade is one of the most popular trading strategies in the forex market. The strategy involves buying higher-yielding currency against a lower interest currency. The traded currency pair interest-rate spreads are high, and the traders in carry trade follow the “buy low, sell high” principle.
For each day that you hold a carry trade, you will receive the difference of the interest between the high-yielding and low-yielding currency from your broker. However, this only happens if your trading leans towards the positive interest direction. Some of the most popular currency pairs used in carry trade includes the New Zealand dollar/Japanese yen pair and the Australian dollar/Japanese yen pair, among others.
The primary purpose of the carry trade strategy is to use leverage or trade-in the margin. It means that you can gain complete exposure to the currency trading market by placing only a fraction of the trade’s total value. The leverage works in your favor if you have a successful trade while it magnifies your loss in the case of an unsuccessful one.
The carry trade strategy has two main components- interest rate changes and the appreciation/depreciation of exchange rates.
- Interest rate changes
The carry trade strategy’s main component centers on two traded currencies’ interest rate differentials. The trader profits from overnight interest payments even if two currency exchange rates remain the same. However, as time goes by, central banks can change interest rates, posing a substantial risk to traders.
- Appreciation/depreciation of exchange rates
Two currencies exchange rate is another component of the carry trade strategy. In this strategy, a trader waits for the appreciation of the target currency when long. The trader’s payoff when this happens includes any unrealized currency profit and daily interest payment. The gain realized by the trader is after the close of trade and appreciating of the target currency.
Steps To Follow When Placing an FX Carry Trade
- First, decide on how you want to trade your currency pairs
- Carry out enough research on the currency pair you want to trade
- Talk to your forex broker for a trading account or create your own
- Ensure that you take the necessary steps to manage any risks
- After opening your trade, monitor the progress, and then close your position
Advantages and Disadvantages of FX Carry Trade Strategy
- A forex trader using the carry trader strategy can only count on steady returns from high-yielding currency pairs as long as they remain stable.
- The strategy works at its best if the high-interest currency rate appreciates. After redeeming the bonds, the trader can use the higher-yielding currency to pay off the low-yielding currency loan and profit from the difference.
- The demand for high-interest currencies increases if enough traders invest in the carry trade strategy, and they can sell on secondary markets at higher profits.
- The value for currency increases the demand for high-interest-rate bonds, which further creates higher profits for higher-yielding bondholders.
- Political events could influence economic outlooks and monetary policies. Some examples of geo-political risks that could change the carry trade strategy include trade wars, sanctions imposed by governments, and Brexit, among others.
- Exchange rate movements in the strategy could affect the interest rate differential returns leading to loss even when there are differential interest rates favoring FX carry trade.
- Unexpected market movements caused by leveraged positions could lead to the stoppage of positions by exchange or losses.
- The uncertainty of exchange rates is the most significant carry trade risk because of the foreign exchange money market’s volatility that changes without any prior notice.
- Risk in interest rates differentials
Wrapping It Up
FX carry trade strategy presents forex traders with exchange rate and interest rate differentials to make profits out of their trading. However, just like any other trading strategy, it comes with both benefits and risks.
Therefore, it is crucial for traders using the carry trade strategy to manage loss risks as they can quickly arise during the currency pair movements against narrows of interest rate differentials or traders. If you decide to go for the carry trade strategy and you are a higher probability trader, look for uptrend entry points and utilize risk management techniques to protect downside risks.