What is carry trading?
Carry trading is one of today's most popular online trading strategies. It takes its origins from the financial concept of a ‘carry’ – the cost or profit associated with holding a particular asset over some period of time.
A carry trade happens when a person sells or borrows an asset with a low-interest rate in order to purchase another asset with a higher interest rate, looking to profit from the underlying interest rate difference. This strategy is heavily used in the foreign exchange market (forex).
How currency carry trades work
In the forex market, currencies are traded in pairs. Let’s say you want to trade USD/CHF. In this case, you actually purchase the US dollar and sell the Swiss franc simultaneously. When trading currencies, you pay interest on the currency position you sell and collect interest on the currency position you buy.
Simply put, a carry trade involves buying a high-yielding currency and funding it with a low-yielding one to make a profit from the interest rate differential – as long as the exchange rate between the two doesn’t change. The currency pairs that are preferred in a carry trading strategy are those with high-interest rate spreads, such as AUD/JPY, NZD/JPY, NZD/CHF, and EUR/AUD.
To be lucrative, the interest rate differential must be greater than the possible weakening of the chosen currencies over the timeframe of the trade execution. Usually, a carry trade is favoured during times of positive global economic performance. If correctly managed, a carry trade strategy has the potential to be highly profitable over a long term run.
Pros and cons of carry trading
Just like any other strategy, carry trading bears a fair amount of risk. Economic and political factors do matter a lot as they can affect interest rates between currencies. Therefore, it is important to control and limit your losses as in any other type of trading.
Now, you might think that carry trading isn't that exciting or profitable. Until it is. First of all, by trading in the direction of positive interest, you receive both trading and interest earnings. Secondly, currency trading can be done with leverage, significantly magnifying your actual gains (and losses). Thirdly, carry trading is flexible, allowing traders to devise different vehicles for downside risk management. And last but not least, traders can hold a position for an extended period of time to make the most of interest rate differentials.
Used along with other trading strategies, carry trading can be a fruitful mechanism in your trading arsenal.