What Is Carry Trade?
The term “carry trade” originates from the financial concept based on profiting from holding (i.e. carrying) an asset. More technically, it is considered a type of “interest arbitrage”.
The strategy first caught traders’ attention in the 1990s. At the time, it was especially popular at hedge funds. Investors noticed big potential interest rate differences between countries like the U.S., Japan, and Australia, where they could reach an impressive 5%. Even now carry trade remains a widely used strategy so it makes sense to learn how you can utilize it to your advantage.
What Is Carry Trade?
Fortunately for traders, a carry trade is a straightforward strategy. It is a method of gaining profits through a high-interest currency against a low-interest one. For example, U.S. dollars are considered high-interest because the USA pays a high-interest rate on its bonds, whereas the Bank of Japan keeps the interest rates low.
A carry trade is a method of gaining profits through a high-interest currency against a low-interest one.
When an investor is holding a trade for an extended period, the interest accumulates for every day the asset is held. Of course, this is profitable when done in the interest-positive direction. Using the examples of high- and low-interest currencies above, a trader can benefit from borrowing JPY to buy USD.
The interest accumulates for every day the asset is held.
The difference between the rates can often be substantial, especially if you invest a large amount or apply leverage. Thus, the potential for big profits makes it one of the most popular trading strategies in the market.
Understanding How Positive Carry Trade Works
A positive carry trade on a high-yielding currency can result in a win if the exchange rate doesn't move or changes to your advantage. However, the opposite scenario can cause large losses. For example, carry trade in large volumes can produce a dramatic depreciation. The interest gained, every single day, can offset the losses from the change. But it’s debatable whether it will cover the loss entirely. Therefore, carry trading should be treated as an additional form of income.
A positive carry trade on a high-yielding currency can result in a win if the exchange rate doesn't move or changes to your advantage.
The Australian dollar has a 4.5% interest rate and the New Zealand dollar – 2.75%. If you buy or go long on the AUD/NZD, you are entering a carry trade. The 1.75% difference will be paid daily, as long as you have that trade open on the market. This seemingly small amount adds up over time.
It is always recommended to apply proper risk management in Forex. The best and most popular currencies are often associated with high volatility. So, instead of being tempted to gain as much interest as possible, you should assess supportive fundamentals and market sentiment.
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