What Is a Carry Trade?

The strategy first caught traders' attention in the 1990s. At the time, it was especially popular with hedge funds. Investors noticed big potential interest rate differences between countries like the US, Japan and Australia, where they could reach an impressive 5%. Even now, carry trades remain a widely used strategy, so it makes sense to learn how to utilise it to your advantage. 

What Is a Carry Trade?

A carry trade is a straightforward strategy. It's a method of gaining profits through a high-interest currency against a low-interest one. For example, US dollars are considered high interest because the US pays a high interest rate on its bonds, whereas the Bank of Japan keeps the interest rates low.

A carry trade is a method of gaining profits through a high-interest currency against a low-interest one. 

When an investor holds a trade for an extended period, the interest accumulates for every day the asset is held. Of course, this is profitable when done in the interest-positive direction. Using the examples of high- and low-interest currencies above, a trader can benefit from borrowing JPY to buy USD.

The interest accumulates for every day the asset is held.

The difference between the rates can often be substantial, especially if you invest a large amount or apply a multiplier. Thus, the potential for big profits makes it one of the most popular trading strategies.

Understanding How Positive Carry Trades Work

A positive carry trade on a high-yielding currency can result in a win if the exchange rate doesn't move or changes to your advantage. However, the opposite scenario can cause large losses. For example, carrying trade in large volumes can produce a dramatic depreciation. The interest gained every single day can offset the losses from the change. But it's debatable whether it'll cover the loss entirely. Therefore, carry trading can be treated as an additional form of income.

A positive carry trade on a high-yielding currency can result in a win if the exchange rate doesn't move or changes to your advantage.

The Australian dollar has a 4.5% interest rate, and the New Zealand dollar's is 2.75%. If you buy or go long on the AUD/NZD, you're entering a carry trade. The 1.75% difference will be paid daily, as long as you have that trade open on the market. This seemingly small amount adds up over time.

Apply proper risk management in forex. The best and most popular currencies are often associated with high volatility. So, instead of being tempted to gain as much interest as possible, you should assess supportive fundamentals and market sentiment.

Advantages and Disadvantages of Carry Trade in Forex

A currency carry trade, like most trading strategies, comes with appealing aspects as well as certain drawbacks. Here are the main pros and cons to consider before adopting this trading tactic.

These reasons make carry trading suitable for those who can accept the high-risk, high-reward strategies. Bear in mind that the appetite for big profits should never be the driving force for your actions. Treat carry trading as an additional method of taking advantage of the market.

Yen Carry Trade Examples 

Let's say a trader wants to benefit from the interest rate of 0.5% in Japan, whereas it is 4% in the US. They expect to gain profits from the difference between them, which is 3.5%. At the time of the trade, the exchange rate is 107 yen per dollar, and the trade volume is 0.5 million yen:

0.5 million yen / 107 = $4,673

The 4% rate on the dollar will result in an annual balance of:

$4,673* 1.04% = $4,856

At the same time, the amount of yen owed will be:

0.5 million yen * 1.005 = 0.503 million yen, which is $4,701

The profit will amount to the difference between the amounts earned and owed:

$4,856 - $4,701= $155

If the exchange rate changes against the yen, the profits may grow bigger. If it moves in the opposite direction, the profits may decrease or even turn into losses.

The calculated profits seem insignificant. However, the prospects seem much better if you use leverage. Now, let's assume a trader wants to invest the same amount for the same currency pair. Libertex offers leverage of up to 1:30, which considerably increases potential profits as well as potential risks.

Essentially, a trader controls 15 million yen or $140,187 worth of that pair by using leverage.

• If the trader leaves that purchase for a year, here is what can happen:
• A trader misjudges an opportunity, and the position loses value. If the drop brings the account down, the trader closes the position with only the 0.5 million/$4,673 remaining on the account, i.e., the funds allocated for the margin.
• The exchange rate of the currencies doesn't change. There is no loss or gain on the value position, but the trader profits from the 3.5% interest (4% for the US dollar – 0.5% of the Japanese yen). This equals $4,907, which is more than the amount in the beginning! This could not be possible without the leverage from the platform.
• The position gains value. On top of getting the $4,907 in interest, the trader may earn additional gains, which often exceed the interest earnings. 

How to Use the Carry Trade Strategy for Trading CFDs

The nature and risks of trading CFDs are quite different. Some say that CFDs are suitable for people who are used to trading in volatile market conditions. However, when you use carry trade strategies on CFDs, it puts a different spin on this otherwise tough instrument.

What are CFDs?

A CFD (Contract for Difference) is a leveraged derivative financial product. The value of CFDs is derived from the value of another asset, which is considered an underlying asset (for example, currencies, stocks or commodities). 

A CFD (Contract for Difference) is a leveraged derivative financial product.

When you buy CFDs, you don't own the asset. Nevertheless, the potential success of your trade depends on how the underlying asset is valued. As a trader, you put trust into the contractor and its sound financial position over time.

How to Trade CFDs Using the Carry Trade Strategy

Regardless of how you trade CFDs, you expect to receive profits from the positive difference between the closing value and the opening value. When you carry trade CFDs, your income partially depends on the increased value of the underlying asset, but you don't rely on the price changes to receive profit. CFDs are complex instruments, and, unfortunately, many investors lose money when trading CFDs. Therefore, you should always consider the risk when deciding if it's worth it.

When you carry trade CFDs, you don't rely on the price changes to receive profit.

CFDs can be traded on a variety of underlying assets, limited to what your CFD broker can access. Moreover, the possibilities continue to expand to a wider range of markets. If you buy CFDs on assets that pay out dividends, then you can combine the profits. Even if the interest rate doesn't yield profits, your chances for a long-term gain rise to a large extent.

When it comes to currency CFDs, you should purchase the ones with a profitable swap and cost-effective prospects.

Conclusion

Carry trading is a strategy that exhibits the potential for profits over time if you manage it accurately. The solid stream of income acts as a safety net. If everything works out as you expected, carry trading can be an additional income.

Libertex contains a hub of articles and guides that will help you navigate different trading strategies available for the money markets, including carry trades. You can find various ways of mitigating and managing certain risks, for example, exchange rate risk.

If you register a free Demo account on Libertex, you can practice carry trading before fully committing to it. This is the best way to introduce yourself to a new strategy or trading in general. Whether you're just starting your trading journey or you want to further improve your skills, you can learn the essentials and apply them in practice on Libertex.