The carry trade is a popular trading strategy used in the FX market. It guarantees traders at least some return on their medium and longer term positions.
In the Carry Trade, speculators buy high interest currencies and sell currencies with low interest rates. These positions ensure that each trading day rollover-interest will be posted to the trader’s account. Thus the Carry Trade has the potential to significantly enhance a trader’s return.
Carry Trade Example
Below is a chart illustrating a typical example where the carry trade strategy could have been best applied. The chart shows a steady increase of the GBP/JPY pair in 2005 and 2006, spawned, among other things, by carry traders going long to obtain the interest rate differential.
A carry trader who took advantage of the interest rate differential in the GBP/JPY would have had the following profit, had he/she bought one standard lot of the GBP/JPY at about the same time last year, and decided to sell a year later.
Setting Up The Carry Trade
To become a successful carry trader, understanding the role that interest rates play in the FX market is a crucial task. A country offering high interest rates will attract more capital as investors seek to capitalize higher returns. As interest rates rise, investment will follow, which can in turn increase the value of the currency. Carry trader’s main focus becomes the expectation on the direction of a country’s interest rate, to ensure their high rate of return.
Generally, traders seek to buy countries with high interest rates, and seek to short currencies who offer low interest rates.
The carry trade works best under certain market conditions, and the selection of the currency pair can make the difference between a losing and a profitable trade. When selecting the currency pair, traders want to observe two things. On the one hand, the trader wants to make sure he is buying the currency that has the higher interest rate and is selling the currency that has a lower interest rate in comparison. On the other hand, the trader also wants to view the health of the economy for the currency pair to ensure the market will move to his/her favor. Essentially, the trader will be buying a currency with a stronger economy and selling the currency with a weaker economy. Some currency pairs that are usually selected to apply the carry trade strategy are: GBP/JPY, GBP/CHF, AUD/JPY, EUR/JPY, CAD/JPY, and USD/JPY.