Carry trading is considered one of the simplest currency trading strategies available. Carry trading occurs when you buy a currency with a high-interest rate against a currency with a low-interest rate. For every day you hold this trade, your broker will pay you the interest rate differential between the two currencies, as long as you are trading in the positive direction of interest.
Advantages of Carry Trading
Trading in the positive interest direction is advantageous because there are interest earnings in addition to your trading profits. Carry trading also allows you to use leverage to your benefit. When your broker pays you the daily interest on your carry trade, the interest is paid on the amount associated with the leverage. For example, if you open a one lot trade ($10,000) and only need to use $250 of actual margin to open that trade, the daily interest will be paid on $10,000, not $250. This can lead to significant annual returns.
Why It Is Risky
There is a moderate level of risk in the carry trading strategy. Currency pairs that have the best conditions for using the carry trading method tend to be extremely volatile. For this reason, you must trade carry positions carefully. Nervous markets can quickly and heavily impact currency pairs considered “carry pairs.” Without proper risk management, traders can be drained by a sudden and severe turnaround.
How It All Fits Together
If you conduct a positive carry trade on a currency pair that pays high interest, and the exchange rate remains stable or moves in your favor, you are a big winner. However, if the trade moves against you, the losses can be substantial. The daily interest payment to your account may reduce the risk, but it is unlikely to be sufficient to protect you from your trading loss. Therefore, interest should be viewed as the “icing on the cake” rather than just an “easy and sensible” strategy.
Like any other trading strategy, use sound risk management and your judgment when making trades. It becomes tempting to reach for that daily interest payment, but without some caution, that small payment can cost you a fortune in losses.
It is best to combine carry trading with supporting fundamentals and market sentiment. Carry trading works best when the market “feels secure” and is in a positive mood. Properly executed carry trading can significantly add to your overall returns.
Source: https://www.thebalancemoney.com/introduction-to-carry-trading-1344843
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