Basics of Carry Trading Forex
Carry trading forex is one of the most simple forex trading strategies for currency trading that exists. A carry trade is when you buy the high-interest currency with a low-interest currency. Each day that you hold that trade, your broker will pay you the interest difference between two currencies as long as you are trading in the positive interest direction.
For example, if the Pound(GBP) has 5 percent interest rate and the US Dollar(USD) has 2 percent interest rate, and you buy or go long on the GBP/USD, you are making a carry trade.
Every day you have that trade on the market, the broker is going to pay you the difference between the interest rates of the two currencies, which would be 3 percent. Such an interest rate difference can add up over time.
Advantage of Carry Trading
Trading in the direction of carry interest is an advantage because, in addition to your trading gains, also there are interest earnings. Carry trading forex allows you to use leverage to your advantage. When the broker pays you the daily interest on your carry trade, the interest paid is on the leveraged amount. If you open to trading for one mini lot (10,000 USD), and you just have to use $250 of actual margin to open that trade, you would be paid daily interest on $10,000, not $250. It can add up to large yearly returns.
Why is Carry Trading Risky?
There is a fair amount of risk to the forex carry trade strategy. The currency pairs that have the best practices for using the carry trading method tend to be extremely volatile. For this reason, carry trading forex must be conducted with care. Nervous markets can have a fast and heavy effect on currency pairs that are considered to be “carry pairs”, and without the proper risk management, traders can be drained by surprising and brutal turn.
The phrase, “carry trade unwind”, is the stuff of carry trader’s nightmares. A carry trade unwinds a global capitulation out of a carry trade that causes the “funding currency” to strengthen aggressively.
How does it all come together?
If you make a positive interest trade on a currency pair that pays the high interest, and the exchange rate stays the same or moves in your favors, you are a big winner. If the trade moves against you, the losses could be valuable. The daily interest payment to account will reduce your risk, but it is not likely that it will be enough to protect you from the trading loss. Carry interest should be viewed as “icing on the cake” rather than only an easy “no-brainer” strategy.
Like any other trading strategy, use a proper risk management, and use your head when making trades. It becomes tempting to reach out for the daily interest payment, but without some caution, that the small payment could cost you a fortune in losses. It is best to combine the carry trading with the supportive fundamentals and market sentiment. Carry trades work best when the market is feeling safe and in the positive mood.