The carry trade is one of the most popular strategies in forex trading. It involves leasing money in a currency with low-interest rates and investing it in a currency with high-interest rates. The balance between the two interest rates is known as the carry.
The carry trade can be profitable if the currency you borrow has a lower interest rate than the currency you invest in. For example, if you borrow the Japanese yen at 0.50% and use the proceeds to buy the Australian dollar at 5.00%, you will earn a positive carry of 4.50%.
How to use the carry trade
Find a currency pair with a high-interest rate differential
The first step in implementing the carry trade is to find a currency pair with a significant interest rate differential. The larger the differential, the greater the potential return on investment.
You can use an economic calendar or a forex broker’s website to determine the interest rates of different currencies.
Calculate the amount of leverage you will need
Once you have found a currency pair with a significant interest rate differential, you need to calculate the leverage you will need to trade it.
Most forex brokers offer leverage of 100:1, meaning you can trade $100 for every $1 you have in your account.
For instance, if you have a $1,000 account and use 100:1 leverage, you can trade up to $100,000.
Select a broker that offers tight spreads
The next step is to select a forex broker that offers tight spreads on the currency pair you are trading.
Spreads are the balance between a currency pair’s bid and ask price. For example, if the EUR/USD bid price is 1.0350 and the ask price is 1.0357, the spread is seven pips.
The lower the spread, the ‘tighter’ it is, and the less you have to pay in fees to your broker.
Place your trade
Once you have selected a broker and calculated the leverage you need, you can place your trade.
You will earn interest on your position if you buy the currency with a higher interest rate (known as going long).
You will pay interest on your position if you sell the currency with a lower interest rate (known as going short).
The carry trade is a popular strategy because it can generate a steady income stream. However, it is essential to remember that leverage can magnify profits and losses.
As such, the carry trade should only be used by experienced traders comfortable with managing risk.
Benefits of using a carry trade
There are several benefits of using a carry trade when you invest.
The carry trade can generate a steady stream of income
The most significant benefit of the carry trade is that it can generate a steady income stream when done correctly, because you are effectively earning interest on your investment.
For example, as mentioned above, if you borrow the Japanese yen at 0.50% and use the proceeds to buy the Australian dollar at 5.00%, you will earn a positive carry of 4.50%.
It means that you will earn 4.50% yearly on your investment.
The carry trade is a low-risk strategy
Another benefit of the carry trade is that it is a low-risk strategy because you are not investing your own money but rather borrowed funds, and you only stand to lose the amount of money you have borrowed.
For example, if you borrow $10,000 at an interest rate of 5.00% and the currency you invest in declines in value, you will only lose the $10,000 you have borrowed.
However, if the currency you invest in appreciates, you will make a profit.
Traders can use a carry trade to hedge against currency risk
Traders can use the carry trade to hedge against currency risk because you are effectively hedging your bets by going long on a currency with a high-interest rate and shorting a currency with a low-interest rate.
For example, if you are worried about the Japanese yen appreciation in value, you could go long on the AUD/JPY currency pair.
It would allow you to profit from the interest rate differential and any appreciation in the Australian dollar.
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