Carry Trade Strategy
Last Update: July 15th, 2019
The carry trade forex strategy operates very differently from other forex methodologies. In contrast to the conventional concepts of buying low and selling high or selling high and buying low, carry Trade forex strategies appear abstract. They typically rely upon a fluctuating market and are therefore useless in a stable market lacking a prevailing trend.
A carry trade strategy allows us to make a profit even when the market is stable as it does not rely on the movement of pricing between two currencies. Instead, the success of a carry trade depends upon the difference between the interest rates of two separate currencies. This is an important distinction, as stable, strong currencies are best suited for executing a carry trade strategy.
What Is A Carry Trade Forex Strategy?
A carry trade forex strategy is the practice of buying currencies with high differential ratios. A differential ratio means that the interest rate of the currency you are buying is higher than that of the currency you are selling. The realized profit will be derived from the difference between the interest rates – the higher the differential, the greater the profits will be.
When selecting prospective targets for a carry trade, we must take into consideration the expected changes in interest rates of both currencies. In practice, a carry trade strategy functions best when the interest rate of the currency we are buying is expected to go up and the interest rate of the currency we are selling is expected to go down. In this way, we stand to optimize the profit potential of each specific trade.
Learn how to Read The Interest Rates – Forex Trading Strategy
When using a carry trade strategy, we make our profit from the differences in interest rates between two currencies. However, that doesn’t mean that the changes in price between the two currencies are irrelevant. For example, if we were to choose to invest in a currency because of a high-interest rate but the price of that currency dropped, the situation is not beneficial. When it comes time to close that trade, we might find that even though we profited from the interest rate a loss was taken on trade because of the difference in entry and exit prices.
Which Currency Pairs Are Best For The Carry Trade Strategy?
For that reason, a carry trade strategy is only fit for a sideways moving market. We must anticipate the movement of the price and only trade if the price is expected to remain more or less the same. Of course, the most profitable way to carry trade forex pairs is to combine it with other trading strategies. By selecting to enter a trade where we stand to profit from both price movement and from the differences in interest rates, we are able to maximize our shot at sustaining profit. However, while they sound easy on paper, finding opportunities like these can be a challenge.
High differential ratios are the first thing to look for when searching for a fitting currency pair. AUD/USD, NZD/USD, AUD/JPY and EUR/JPY are the most popular currency pairs when using a carry trade strategy as they represent very stable economies which have low-risk currencies. Given the consistent economic growth and active central banking intervention, these pairings are ideal places to find carry trade forex opportunities.
Remember, the differential ratio of a pair when buying is always the opposite of the differential of a pair when selling. This is an important point, so don’t get confused! Only enter a trade if it first exhibits a positive differential ratio.
If the differential ratio is expected to grow, meaning that the interest rate of the stronger currency is expected to increase and that of the weaker currency is expected to decrease, then mark that currency pair as suitable for the carry trade strategy. Before placing the trade, make sure that the currency pair has been stable for a long time. Ideally, the pair should be in a slight upward bullish trend in order to avoid any unexpected market corrections.
Integrating the carry trade forex strategy into your approach to the markets is a good way to diversify risk. While technically one still buys and sells currency pairs to execute a carry trade strategy, the ultimate objective is different. By targeting strong currencies in stable environments, one is able to capitalize on appreciating pairs while eliminating the downside risk of aggressive short-term trading.