Carry Trade Forex Strategy
Carry trade involves borrowing a currency with a low-interest rate and using the proceeds to invest in the high-yielding currency. The strategy can be highly profitable given the highly leveraged nature of the forex market due to which the returns are highly magnified. However, if the exchange rate moves against you, you will end up losing money. The interest is calculated daily and credited to your trading account.
What currency pairs to use for carry trade?
Japan has been historically maintaining lower interest rates, almost close to zero, so traders often borrow JPY since the cost to borrow it is minimum. The currency that you should buy using the proceeds from the borrowed JPY should ideally be the one that is stable and offers a higher yield.
Traders often use AUD/JPY and NZD/JPY currency pairs for their carry trade strategy.
How to perform carry trade profitably?
Carry trade, like all trades, carries risks. The exchange rate might go against you or the central bank might lower the interest rate, resulting in lower yield. To manage the risk, you should invest in three pairs of currencies, all with high-interest rate differentials. This will diversify your portfolio and will reduce your risk of losing money as loss from one currency pair will be offset by the gain in others. Many financial institutions and hedge funds employ this strategy and hold the currencies for the long term to gain the benefits of high-interest rates while leveraging their positions.
Many traders recommend going long on the high yielding pair as shorting the pair will lead to higher incremental cost with each passing day in the shape of interest payments, whereas going long on the pair earns you interest every day, which reduces the average cost of the trade. Furthermore, due to the high demand for carry trade currency pairs, the trend normally remains directional. Therefore, you should refrain from doing contrarian trading as it will dent your account severely.
Carry trade is a popular forex trading strategy, which you can use to your advantage by employing various tactics As mentioned earlier, you can diversify your risk and can trade carry profitably by following the methods mentioned above. However, you should keep yourself updated about the risks associated with the trade and the currencies in the pair before going into the trade