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