What is Carry Trading in forex?
What is Carry Trading in forex?

What is Carry Trading in forex?

Trading Forex (foreign currency or FX) using a carry trade strategy can be a profitable and relatively safe investment method; however, there are some risks involved in attempting carry trading forex. First of all, let us clarify exactly what carry trading entails.

The strategy involves the forex trader buying a currency with a relatively high-interest rate while selling another currency with a lower interest rate. The difference in these two interest rates is the yield that the investor will generate, the overall amount depending on the leverage used, and how long the trade is held. Generally speaking, a carry trade strategy is longer term than most currency trades. For example, investors in foreign currency carry trading will hold their trades for weeks and months rather than minutes and hours like some day traders.

An example of carry trade in foreign currency would be a trade involving GBP, the British Pound, and JPY, the Japanese Yen. In this case, an investor would go long on the pair GBP/JPY, borrowing Yen to buy the Pound. Assuming that the Yen interest rate is .25% and the Pound is 4.75%, the carry trader will yield a profit of 4.50%. If the forex trader is using a great deal of leverage, the APY on the investment can be many times greater than that simple difference.

Risks of forex trade for the carry interest

There are several risks involved in attempting to benefit from holding a forex trade for the carry interest. First of all, the interest rate differential for the pair could decrease, thus rendering the trade less effective. Second, if the rates close while the overall trade is in a losing position, the trader may be left actually paying interest before being able to close the trade for a profit. Finally, the most problematic element for the forex carry trade strategy is that the pair's value moves against the trader so much that the loss on the trade exceeds any possible gain from the interest. This risk is compounded depending on the amount of leverage the forex trader is using. As with other forex trading strategies, leverage is a double-edged sword.

How to increase profits?

The trader may realize terrific gains using a high amount of leverage, but the risk also increases. To fully maximize the benefits of the carry trade strategy, leverage is an essential tool; however, with high leverage, the trade can turn into a loss with only minor movement in the pair. In the example above, a carry trade involving the GBP and the JPY, the trader hopes that the Pound will remain strong throughout the trade while the Yen loses value. However, if the converse happens and the GBP/JPY falls, depending on the level of leverage used, the trader can lose an entire year's worth of interest gains with only a tiny drop.

As with all forex trading strategies, the carry trade needs careful analysis and a methodical approach. The forex trader needs to understand both the benefits and dangers of leverage. Rather than depending solely on a carry trade to make profits, it is generally a better idea to use it as one tool among many in the forex trader's toolbox.

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