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Trading in the FOREX market is attractive for many reasons, one of which is there is a lot of room for creativity in how you approach FOREX trading.
Along with using traditional techniques to make profits, there are various ways to trade and earn money as long as you are willing to be flexible and proactive in your approach.
Buying low and selling high is the usual way of making money in FOREX trading, however, it is not everyone’s cup of tea since it requires a lot of work. It’s worth knowing that there is a simpler and easier alternative to this - carry trading.
What is Carry Trading?
Carry trading is a popular trading strategy among professional FOREX traders which involves taking advantage of the difference between interest rates of two currencies and ensures positive net profit in a relatively longer time frame assuming the exchange rate between the two currencies stays the same.
The carry trading FOREX strategy entails borrowing a currency which has a low interest rate (known as the low-yielding or funding currency) and using it to purchase a currency that has a higher interest rate (also called the high yielding currency).
A trader, in this scenario, can earn profits in two ways.
Firstly, the difference between the interest rates of the two currencies and, secondly, the trader can profit on the exchange rate difference by an appreciation of the higher yielding currency against the low yielding currency.
Why use Carry Trading?
Carry trading is a popular choice due to the various potential benefits it offers.
One of the most important positive aspects of using this strategy is the fact that it entrenches long-term profitability barring rare cases of a sharp drop in the value of the bought currency.
This is quite opposite to most other FOREX trading strategies which have a higher probability of suffering losses in the long term.
At the same time, there are two sources of profits as we discussed earlier which are likely to increase the overall profitability of the trader.
It can be examined from the above discussion that carry trading is also a relatively simple strategy to use in the real market. This means that it is less time consuming than conventional FOREX trading techniques and strategies and moreover, traders of this strategy consider it to be a less risky strategy overall.
Lastly, carry trading is likely to be extremely profitable in growing global markets and it can be a losing strategy during market downturns and recessions.
How to use Carry Trading?
Using carry trading is a rather simple process. However, data analysis, research, and focus are essential to remain successful and profitable for a long period of time.
The first step is related to finding a high rate differential. It is important to understand the basics of choosing the right currency pair. What you need to understand is that a trader is always buying one currency and selling another during every FOREX transaction. Choice of an appropriate currency pair is crucial for every FOREX trade; however, the importance is increased when carry trading is considered.
For the last two decades, low-yielding currencies such as the Japanese Yen (JPY) and the Swiss Franc (CHF) have been the top funding currencies for carry trading. On the other hand, investors have been using the Australian Dollar (AUD) and the New Zealand Dollar (NZD) for the purpose of earning their high yield. Consider the following example to understand how this works in reality.
The high-yielding AUD and NZD appreciated versus the low-yielding Yen during times of economic expansion and fell sharply during the 08 – 09 US recession (AUDJPY and NZDJPY exchange rates 2000 – 2017)
Suppose that the base interest rate of the Swiss Franc (CHF) is 0.5%. While the base interest rate of the Australian Dollar (AUD) is 2.0%. Borrowing the Swiss Franc at a 0.5% interest rate and using this money to buy the Australian Dollar (AUD) and reinvesting it at 2.0% will result in a gross interest rate difference of 1.5%. The net profit is likely to be further increased if the AUD exchange rate appreciates against the CHF for the holding time of the position.
Is there a risk involved?
No trading strategy is perfect and that holds true for carry trading as well. While it is true that it involves somewhat less risk than other standard trading strategies there is still risk involved and the possibility of incurring losses.
The primary risk involved with this strategy is related to unfavorable movements in the exchange rate of the traded currency pair. Specifically, a depreciation of the high-yielding currency and/or an appreciation of the low-yielding currency can outweigh the positive net interest income.
Hedging strategies via futures or options markets can be used to hedge the risk of exchange rate fluctuations in such a situation.
Conclusion:
This article has explained the significance of using carry trading as a primary FOREX trading strategy. A well-chosen currency pair can result in a substantial amount of profits, however, in the long run, care must be taken as some amateur traders often get themselves involved in a negative carry trade when the net profit earned from holding a currency fails to cover the profits made on.
A fair deal of research, practice, and experience is essential to ensure that you always enter into a positive carry trade.
