How To Carry Trade?

In currency markets, carry trading is done by many investors to take benefit of the basic economic principle that money flows where the returns are high. This constant flowing in and out of capital between the different markets is what makes carry trading profitable.

Carry trading is a popular trading strategy employed by professional forex traders. Hedge funds and investment banks use leveraged carry trading as one of the favorite strategies. Retail forex traders can also benefit from carry trading.

Carry trading means taking benefit of the interest rate difference between two currencies. Carry traders take benefit of the interest rate differential between two currencies by buying or going long on the high interest rate currency and selling or going short on low interest rate currency.

Lets make it clear with a simple example: suppose New Zealand dollar is offering an interest rate of 4.75% while the Japanese yen is offering an interest rate of 0.25%.

An investor who wants to capitalize on this interest rate differential will buy New Zealand dollars (NZD) and sells Japanese Yens (JPY). The investor can earn a profit of 4.75-0.25=4.5% as long as the NZD/JPY exchange rate does not change. If the investor uses a leverage of 10:1, this 4.5% return will be magnified into 45%.

If the currency pair NZD/JPY appreciates, the investor can get a capital gain as well as a yield on the investment. When there is a carry trade opportunity, many investors jump on the bandwagon. The more investors carry trade, the more the currency pair appreciates.

It depends a lot on the mood of the investors as a group. If investors as a group have low risk aversion, carry trading will be profitable. But if the investors as a group suddenly develops high risk aversion, carry trading will become unprofitable.

When an investor enters into a carry trade, an investor expects to profit from an interest rate difference between a currency pair. But in case, low interest currency appreciates considerably for different reasons, carry trade will become unprofitable.

So it essential when you determine a currency pair for carry trading, you also identify the current trend of the currency pair to see whether it is moving in the right direction.

MACD (moving average convergence divergence) indicator can help you in this regard. You should enter the trade when MACD crosses the zero line from below. You should exit the trade when it crosses the zero line from above.

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