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When you trade the financial market, you don't just make money through the spread between your long and short positions. One way to generate another line of profit is through carry trading.
In its most basic form, carry trading is the strategy to take advantage of the asset's interest rates. It includes borrowing or selling a currency with a low interest rate and then buying the other with a high-interest rate.
Before defining how currency carry trading works, let's review the logic behind forex trading. Here are the core components of forex trading:
But what's its relevance to carry trading? Carry trading offers traders an alternative to the tradition of "buying high, selling low" trading.
In forex trading, when you buy a currency pair, you borrow a currency with a low interest rate and use it to fund your purchase for a currency that gives out a high interest rate.
When you carry trade, you essentially open another way to generate profit besides the appreciation and depreciation of the traded currency pair. You use the interest differential between the currencies involved to create profit.
As enticing as it sounds, carry trading requires traders to know the central banks and other economic news of the currencies involved. This means that you must closely monitor the news to ride the potential opportunities of exchange rate differential.
Here is Josh's trading situation to better understand how carry trading works to generate more profit.
Josh has received $10,000. As an investor, it's in his nature to never let his money sleep on his wallet. So, he found a way to grow his $10,000 capital through carry trading.
Upon researching, he noticed that carry trading AUD/JPY has great profitable opportunities. The Reserve Bank of Australia (RBA) offers a 2.5% interest rate, while the Bank of Japan (BOJ) has a 0.1% interest rate.
With this, Josh decides to carry trade the AUD/JPY-- borrowing funds in JPY using the BOJ interest rate and investing borrowed funds in AUD to profit from the high RBA interest rate.
Carry trading is a popular strategy in the forex market due to its potential to drive up the profit of your position. When you carry trade, your profit goes beyond the usual profit through pip movement.
By leveraging the interest rate differentials, you can earn interest income while holding positions in currency pairs.
Currency trading encourages you to engage in other currency pairs aside from the popular majors. Essentially, your basis to open a certain position is their central banks' interest rate.
This carry trading advantage helps you in managing market risks. By diversifying your portfolio, you reduce overexposing your investment to a single risk and enhance returns by opening different assets.
Carry trading is highly knotted with high leverage trading. When you trade with leverage, you magnify potential losses because your relatively smaller account carries a high notional valued position. Hence, any market movement would significantly affect your trading account.
The interest rate for each currency is not fixed; it's subjected to the risk of interest rate fluctuation. So, carry trading is also a matter of speculating the economic movement of the involved currency on your trade.
To combat this risk, you should always speculate on the news of their respective central banks to predict and manage potential fluctuations.
Currency carry trading exposes investors to country-specific risks associated with the traded currencies. Factors include political instability, economic conditions, regulatory changes, and geopolitical events in the countries involved. Such market news significantly impacts the currency values and carry trade profitability.
For the next lesson, you'll learn the best practices for deciding when to carry trade. Specifically, you'll explore what is at stake when you fail to recognize the optimal time to carry trade.