Carry trading strategy explained

  • By Noah Schumacher

  • July 18, 2018
  • 12:41 pm BST

Carry trading strategy is one of the fundamental trading strategies. The main idea is to purchase a currency with a high interest rate and to sell a currency with a low one. To do this as a trader, you’d typically borrow an inexpensive currency with a low interest rate, such as the Japanese yen. Then, you’d invest in more profitable ones or stronger currencies with ‘better’ rates, such as the Australian dollar. So the yen is the funding currency while the Australian dollar is the investment currency. This means the flow of funds to Australia from Japan swells and Australian dollar demand goes up. Why? Capital flows increase because traders want to invest in more profit-making but risky currencies. Risk-on sentiment has this effect.

Swapping positions

A swap involves moving open positions from one trading day to the next. With this extension comes having to deal with either a cost or a gain, which is interest rate dependent.

An example would be if the Australian dollar had a higher interest rate than the Japanese yen and you bought an AUD/JPY pair. You’d profit from the difference in interest between the two currencies, or swap, for each day you hold the trade overnight. But if you were to sell AUD/JPY, you’d pay the swap instead for every day this trade position was held overnight.

How do you know if a pair will give you a profit?

As far as forex advice goes, finding a good pair is fairly simple. You need to monitor the trends relating to the pair in the long term and how they have been interacting for a few years.

Firstly, find a pair with a high interest rate differential. Preferably, the two individual currencies should both be fairly stable in their own right. Check to see that the pair has been stable or in an uptrend that has gone in favor of the higher-yielding currency. You want to stay in the trade as long as possible to be able to benefit from the interest rate difference.

The defining characteristics of carry strategy: What you need to remember 

  • This strategy is a long-term one; it is not for the short-term. You must therefore be comfortable with working on big time frames, including knowing how to discern temporary trend distractions from finite ones that could spell disaster for your strategy. Is something a two-week reversal or a complete global trend reversal? You need to know the difference. You also need the disposition to be able to open up a trading position for several months without panicking.
  • Keep the principles of fundamental analysis in mind all the time. Keep an eye on interest rates and the fact that they could change permanently. Anticipate rate hikes or declines before the market does. Know what you will do as a backup in the event of a market crisis, bearing in mind that it wouldn’t be a market crisis if every trader had seen it coming.
  • This strategy only works in a stable market, because then the market is not as risk-averse as it otherwise might be. In times of turbulence, only the bravest traders will take on even the slightest risk.

Carry trading strategy is a simple strategy that doesn’t require an advanced level of knowledge. It does not necessitate, for example, the level of trading experience that should be in place before you attempt to learn CFDS. What you do need is market awareness, the ability to identify a good pair, and the patience to sit out a trading position for a few months.