Forex Carry Trade Strategy: Ultimate Guide

What is a Carry Trade？

Carry Trade is a smart strategy used by forex traders to make a profit by taking advantage of the interest rate differences between two foreign currencies in a pair. This clever tactic can either be positive or negative depending on the currency duo being traded. By following this strategy, a trader can cash in on the differences in interest rates between the base and secondary currencies in a forex pair.

• Positive carry trade = buying at a high-interest rate / borrowing at a low-interest rate

• Negative carry trade = buying at a low-interest rate / borrowing at a high-interest rate

For example, lets 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%).

The Carry Trading Advantage in Forex Market

Carry trades find the perfect haven in the Forex market since it operates through currency pairs. It involves a trader borrowing or selling a currency with a low-interest rate to buy another currency with a higher interest rate.

As an illustration, if you purchase the EUR/USD exchange rate, you essentially acquire the euro and sell US dollars concurrently. The good news is, you don't necessarily need euros or dollars in your trading account as the broker manages all the currency conversions invisibly, allowing for seamless transactions. This approach allows the trader to pay a lower interest rate on the borrowed currency while earning a return on the higher interest rate of the purchased currency, resulting in what is known as the interest rate differential.

How Carry Trade Works in Forex Trading

Forex carry trading is a strategy that involves borrowing a currency with a low-interest rate and investing in a currency with a higher interest rate. The goal is to profit from the difference in interest rates between the two currencies.

Heres how it works:

• First, the trader borrows a currency with a low-interest rate and uses it to purchase a currency with a higher interest rate. This creates a “carry trade” as the trader earns the interest rate differential between the two currencies.

• The trader will hold the position for an extended period, typically weeks or months, to earn the interest income. During this period, the trader will monitor the exchange rate to ensure that it remains stable or increases. If the exchange rate falls, the trader could lose money even if they are earning interest income.

Overall, the success of carry trading is dependent on the interest rate differential and the stability of the exchange rate. This strategy can be risky, and traders should use caution and risk management techniques to protect their investments.

Example of “Carry trade in Forex trading.”Suppose a trader deposits £1000 into a forex trading account and decides to execute a positive carry trade by trading the AUD/JPY currency pair, which has a 5% interest rate differential. With a leverage ratio of 20:1, he can open a position for £20,000, where the deposit represents only 5% of the total value. The carry trade strategy can have different outcomes depending on the direction of the market. If the currency pair's value appreciates, the trader will receive a 5% interest rate on the full position value, along with any associated profits. In contrast, if the currency pair's value depreciates, the trader may incur losses and could be forced to close out the position when the remaining amount is the 5% margin of £20,000. If the currency pair's exchange rate remains unchanged, the trader will earn 5% interest on the leveraged trade without any additional profits or losses.

Which Forex pairs make the best Carry trades？

A positive carry trade in forex involves pairs that are ideal for earning profits based on their interest rate differences. The best currency pairs for this strategy are those in which the Japanese yen (JPY) or Swiss franc (CHF) serves as the secondary or quote currency. These currencies are perfect due to their low yields.

For example, AUD/JPY or AUD/CHF is the most preferred currency pair for carry trading as the Australian dollar has a much higher yield compared to the low-yielding JPY or CHF. This approach helps traders to earn a decent income from the interest rate differential between currencies.

Carry trade based on News Releases

The stability or instability of an economy refers to the overall strength and health of a country‘s financial system, including factors such as inflation rates, employment levels, and overall economic growth. When an economy is stable, it tends to attract investment and trade, leading to an increase in demand for the country’s currency. Conversely, when an economy is unstable, investors may lose confidence and begin to withdraw their investments, leading to a decrease in demand for the countrys currency.

In the forex market, carry trade rates are influenced by the stability of economies because interest rates are one of the key drivers of currency values. When a countrys interest rates are high, its currency tends to appreciate in value, as investors seek to earn higher returns on their investments. Conversely, when interest rates are low, the value of the currency tends to decrease, as investors may seek higher returns elsewhere.

However, interest rates are not the only factor that influences the value of currencies. Inflation, geopolitical events, and other external factors can also impact the value of currencies, leading to fluctuations in exchange rates. As a result, forex traders need to stay informed about the latest economic and political developments in the countries whose currencies they are trading. By using our Economic calendar, traders can stay informed about current market events.

Leveraged Carry trade in Forex

The popularity of carry trade strategy trading in the Forex market is largely due to the availability of trading on margin, which allows traders to control a significant amount with only a small deposit. To gain a better understanding of the risks associated with margin trading, you can refer to our article “What is Leverage in Forex Trading？”.

Example of using Leverage in Carry trade:

Lets assume that a trader wants to execute a carry trade with the Japanese yen (JPY) and the Australian dollar (AUD). At the time of the trade, the interest rate in Japan is 0.1%, and the interest rate in Australia is 1.5%.

The trader decides to borrow 10,000 JPY and convert it into AUD, giving them 122.79 AUD (based on the exchange rate at the time of the trade). The trader then invests the 122.79 AUD in a high-yield Australian bond with a 1.5% interest rate. Assuming there are no fluctuations in the exchange rate, the trader would earn 1.5% on the investment, or 1.84 AUD.

Now, lets assume that the trader decides to use leverage in this carry trade by borrowing more JPY than they actually have. If the trader uses a leverage of 10:1, they would be able to borrow 100,000 JPY instead of 10,000 JPY. This would allow them to invest 1,227.90 AUD in the high-yield Australian bond.

Assuming there are no fluctuations in the exchange rate, the trader would earn 1.5% on the investment, or 18.42 AUD. However, because the trader borrowed more JPY, they would also need to pay back more in interest. With a 10:1 leverage, the interest cost on the 100,000 JPY borrowed would be 1% or 1,000 JPY.

So, the traders net profit would be the interest rate differential (18.42 AUD – 1,000 JPY = 8.42 AUD). By using leverage in this carry trade, the trader was able to increase their investment and potentially earn a higher profit, but they also took on more risk due to the higher amount of borrowing.

Benefits of Carry Trades:

Carry trades come with certain advantages that can help you make more profit with your trades. When you borrow money to make a trade, you can earn interest on the borrowed amount in addition to any profits you make from the trade. This interest is based on the full amount you borrowed, not just the small amount you put in yourself.

Carry trading can be a good way to make money when the market is not moving much, but you still need to manage the risks. This means setting up stop-loss and take-profit orders before you make the trade, so you can limit your losses and take your profits when the time is right.

Risks of Carry Trades:

The use of a carry trade strategy is associated with certain risks. Low-interest-rate countries, for example, are low-interest-rate countries for a reason. When the economy is struggling, central banks typically keep interest rates low to encourage consumers and businesses to borrow, spend, and invest. If the economy starts to grow again, the central bank may raise interest rates to prevent it from overheating, which would affect carry trades.

Besides the risks of carry trades, you also risk losing money if the market appreciates or depreciates. It is possible for the trader to receive a positive daily interest payment and a positive carry if they go long or buy a market. It is possible, however, that the loss of the investment would exceed the positive daily interest payments if they exited the investment at a lower price.

To Conclude

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. 

Use Risk Management - Since the best currencies for this type of trading tend to be those with the highest volatility, negative market sentiment can quickly and heavily impact “carry pair” currencies. Unexpected, brutal turns can wipe out a trader's account without adequate risk management. As a rule of thumb, carry trades are best entered when fundamentals and market sentiment are in favor of them. Positive market sentiment and investors in a buying mood are the best times to enter these strategies.

Disclaimer: This post is from Aximdaily and it is considered a marketing publication and does not constitute investment advice or research. Its content represents the general views of our editors and does not consider individual readers personal circumstances, investment experience, or current financial situation.