This article will describe this long term trading strategy used mostly by institutional investors. We will be highlighting rewards and risks in a simple way to make it possible for you to use it as well.
With carry trading, you can make or lose money even if the price of a currency pair remains static for a long time. It will also help you understand the reasons behind some of the market’s moves, especially during volatile and risk-off periods.
What is carry trading?
Even though it is possible to have carry trades in a variety of financial instruments and investments, the basic premise is the same.
Positive carry trading occurs when someone borrows an asset with low interest rates to finance the investment in an asset with a higher return. For example, borrowing money at 2% and then investing the funds in an asset that pays 5%. This is easily done in the Forex market because currencies are traded in pairs, so a positive carry trade is obtained when a trader buys (“carries”) a high interest rate currency (for example, AUD) and sells a low interest rate one (such as JPY).
Negative carry trades, as expected, are the opposite of positive carriers strategy. This situation happens when the yield of holding an asset isn’t sufficient to cover its financing costs. For example, shorting AUD/JPY.
So how does this type of trading work in Forex?
Because you’re holding positions overnight, interest much be debited/credited when the contracts are swapped, depending on the interest rate differential between the two currencies, and whether you’re long or short. You always “receive” interest on the currency you own, and “pay” on the currency you sell. Then the differential is debited/credited on the account.
If the currency you bought had a higher interest rate than the other one in the pair, that’s a positive carry. The opposite would be the negative carry.
How to make profit with this financial instrument?
The best potential carry trades are obviously the ones where there is a big interest rate differential between the two currencies, but that alone is not enough. For a trade to be profitable, your position should at least maintain its value over time. However, in some cases, if the interest rate differential is very big it may be possible to make money even if the market moves slightly against your position.
Remember this type of trade does not yield good profit in a very short run. Instead, the trade yields good profit with a long term strategy.