The idea of carry trade is very simple. One borrows a financial instrument (for example, GBP currency) to purchase another financial instrument (for example, USD).
As a result, you can collect higher interest on a purchased financial instrument compared to the interest rate you pay for the borrowed or sold currency. So, the interest rate differential actually forms your profit.
In this article, we will explain the currency carry trade definition. You will also learn more about carry trade strategy benefits and risks as well as how it works.
As stated earlier, the whole idea of the carry trade strategy relies on finding and borrowing low-yield currency and using it to buy the one with a higher yield. The difference between interest rates will make your gains. To succeed, traders need to find currency pairs with a high-interest rate spread. The most popular assets include AUD/JPY, NZD/JPY, and some more.
Despite the fact that interest rates are quoted annually, they can still change at any moment depending on the economic and geopolitical situation. These changes may happen whenever central banks decide to interfere. Meanwhile, some countries try to keep high and low-interest rates for as long as possible to let traders ensure a favorable outcome. As a rule, a carry trade strategy is supposed to hold open positions for about several months.
Generally, the approach is considered a risk-free strategy. However, investors should avoid common mistakes and pitfalls. They may include depreciation of the target currency. It can erase all potential profits. The best way to use the carry trade approach is when a targeted asset features low volatility.
To bring the strategy to life and execute a carry trade, market participants can select from two major options:
The first approach potentially looks more profitable. However, it also involves certain risks some traders are not eager to take. This is why they prefer the second approach.
To understand how carry trade works, we need to understand how the interest rate works in the market. First of all, it is a rollover rate that is charged as a daily fee for those who prefer holding their positions overnight. Interest rates can be either positive or negative.
Set by central banks, interest rates are steady under normal market conditions. Oppositely, when the market is uncertain or stressed, the situation can change drastically and so does the interest rate. A good idea for traders is to keep a calendar with all recent central banks' decisions made.
To make the most of the carry trade strategy, you need to select an asset with a high-interest rate as the base currency and a secondary asset (currency) with a low-interest rate. When applying this approach, one should consider the secondary asset as the most important one.
Over the years, JPY and CHF have been the most popular secondary assets among investors who use carry trade. However, more options involve currencies issued by countries with a healthy economy. Which means lower investment risk. They include:
The main drawback of the strategy is that carry traders heavily rely on the interest rate. The slightest change or unexpected move leads to a disastrous failure. What’s more, traders sometimes do not even know where those changes may come from. If the market starts moving against the investor, the rate differential is likely to wipe out all potential profits.
For instance, we all know JPY is a very popular asset and is regularly used to execute carry trades. Investors use it, as Japan usually maintains close-to-zero interest rates. On the other hand, when the crisis broke out in 2008, high-yield asset interest rates were cut making the interest rate for the yen insignificant. Carry traders had nothing to do but unwind the asset.
The first and foremost advantage is the ability to make a good profit. Interest earnings make the approach very attractive. Secondly, your broker makes interest payments that are on the leveraged amount. In other words, you will need less money to open a big-sized lot. It will depend on the particular wagering requirements established by the trading platform. Make sure you select the best service provider.
Another great benefit is the ability to generate profits in the long run. Traders can make regular returns but only if the market conditions are stable. The strategy will definitely make sense in times of low volatility. At the same time, traders should be always aware of the risks brought by trading. So, comprehensive money and risk management approaches are vital. Make sure you place stop loss and take profit orders before entering the market with a position.
This material does not contain and should not be construed as containing investment advice, investment recommendations, an offer of or solicitation for any transactions in financial instruments. Before making any investment decisions, you should seek advice from independent financial advisors to ensure you understand the risks.