How to Trade the Forex Market Using the Carry Trade Strategy

The carry trade strategy has become quite popular among forex traders. This is because the strategy is quite simple, highly productive, and comparatively safer. 

If you wanted to learn the carry trade strategy, then you are on the right platform. Because in this article, we are going to discover the carry trade strategy and learn how to apply it to the forex market for potential profit opportunities. We shall also discuss some practical tips and techniques along with an example for a better understanding of carry trading. Let’s begin right away.

What is the carry trade strategy?

The carry trade strategy involves profiting from the interest rate differential on two currencies given in a Forex currency pair. It has become quite a popular Forex trading strategy that involves two currency pairs far more than often. These currency pairs are the Australian dollar/Japanese yen and the New Zealand dollar/Japanese yen. The interest rate spreads of these currency pairs remain quite high and therefore, these are the best pairs for carry trading.

How does the carry trade strategy work?

The carry trade strategy is a simple strategy where traders seek the maximum interest rate spread between two currencies of a given currency pair. Firstly, traders identify such a currency pair. Secondly, they borrow funds in a currency with a low-interest rate and use the amount to buy a currency with a higher interest rate. Thus, they aim to capitalize on the interest rate difference between the two currencies. 

How to implement the carry trade strategy in forex trading

As you have already understood carry trading refers to capitalizing on the interest rate differential between the two currencies. You can follow the following steps to implement the strategy with ease.

1. As you already know, the first step is to identify a currency pair that suits the carry trade strategy. However, it is important to use a pair with the highest interest rate differential. Such a pair offers maximum return on your investment. 
2. Analyzing the market using both fundamental and technical analysis is extremely crucial. This is because you have to analyze, on one hand, economic data and news events to determine whether currencies in your chosen pair will appreciate or depreciate. On the other hand, you need technical analysis to find potential trading opportunities. 
3. Choosing a broker is also crucial when implementing this strategy. How so? Because you need a broker that not only allows carry trading but also offers competitive interest rates and low spreads. 
4. After completing the first three steps, you can finally place a trade. The principle is to go long on the currency with the higher interest rate. Conversely, go short on the currency with the lower interest rate. In the simplest terms, what you have to do is borrow currency with a lower interest rate. And invest in the currency with a higher interest rate.

So, implementing the carry trade strategy is easy. However, it is also important to keep monitoring your position. Keep tabs on the economic data or any new developments so that you could adjust your positions accordingly. 

A practical example to understand carry trading

Let’s suppose that you want to carry trade the AUD/JPY currency pair. You analyze that 0.25% is the current interest rate in Australia is 0.25%. Whereas, – 0.1% is the current interest rate in Japan. Now, you will follow the following steps to implement the carry trade strategy.

1. Firstly, you will borrow currency with a lower interest rate and that is the Japanese yen (JPY). Let’s suppose that you are borrowing 100 million JPY at an interest rate of -0.10%.
2. Secondly, you will sell JPY and buy Australian dollars (AUD). Suppose that the exchange rate is 1 JPY = 0.012 AUD. So, you will get 8.33 million AUD.
3. Thirdly, the easiest way is to invest the AUD in an interest-bearing account in Australia. The aim is to earn a higher interest rate than you have to pay on JPY. Let’s say that you invest 8.33 million AUD in an Australian savings account offering 0.25% interest per year.
4. Fourthly, you can go on to hold your position for as long as you like to let the interest accumulate. Let’s say that you hold your position for one year and earn interest up to 20,825 AUD. 
5. Finally, close your position by selling AUD holdings and converting to JPY to return the borrowed amount. 

So, we can see that the trader earns the difference between the interest earned on the AUD investment and the interest paid on the JPY loan. According to the example, if the exchange rate after one year is 1 AUD = 82.50 JPY, you will get 686,625,000 JPY. However, you have to return 100,100,000 (100,000,000 + (100m * 0.1%)). The difference between both amounts will be your net profit. 

The wrap-up

Simply put, the carry trade strategy involves capitalizing on the interest rate differential between two currencies of a given currency pair. So, we can conclude that the strategy is profitable but when traders earn more interest than interest to be paid plus any other costs associated with borrowing and investing. Moreover, currencies are also subject to appreciation as well as depreciation. Therefore, traders may also face significant losses if the market moves against them. So, it is important to use both technical and fundamental analysis to measure and manage risk.