Continuing to learn about Forex trading and the market can lead to more and more new ideas and concepts to learn.
One strategy that you may have heard of, but may not understand, is carry trading. We will explain what this strategy is, how it works, and whether carry trading is a good strategy for you to employ.
How a Carry Trade Works
To put it simply, carry trades in Forex is when you borrow one currency and then use it to buy another, different, currency.
As an example, let’s say you borrow (sell) $1,000 Canadian dollars, and use those funds to buy an equal amount of GBP. This type of strategy is very popular in Forex because some currencies weigh more than others due to inflation and varying interest rates.
Why is Carry Trading Popular?
You may ask yourself why carry trades in Forex are so popular in the market. There are two main elements of this strategy that make it appealing to traders: currency pairs and leverage.
Currency pairs refer to the fact that currencies are traded in pairs, one with a high interest rate, and one with a low interest rate. This makes it very easy for traders to make a profit on the market.
Leverage is a big part of why this strategy is able to produce a sizable profit. Many Forex brokers can make leverage up to 500:1 on some currency pairs. Basically, this means that $500 in one currency can buy $50,000 at 100:1 leverage. Based on this, even though the percentage of profits is low, they are still meaningful.
Popular Forex Pairs to Carry Trade
Now that you know how carry trades in Forex work, you might be on the lookout for which currencies to use this strategy on. There are a few popular choices among traders, on both the buying and selling sides.
For selling, the Japanese Yen is chosen most often due to the low borrowing cost in Japan. The British Pound is also a popular selling choice due to the same reason.
As for buying currencies, the Australian and New Zealand Dollar are very popular choices because of the stable, high interest rates.
Benefits of Carry Trades
This strategy is best used as a long-term investment. Because the interest rates in currency pairs are different, you could still benefit from a carry trade even if the rates do not change. If the rate does happen to change in your favor, you could gain a substantial profit when you factor in the leveraging used.
Risks Involved in Carry Trading
While carry trades in Forex are generally very low-risk, there are always things to keep in mind when trading on the market. One thing to watch out for is when the market moves. If it moves too much, it could invalidate the profits you gained from the interest difference of currency pairs.
Make sure you also keep in mind that the monetary policy may change at any time. Right now, coming out of a worldwide pandemic, many countries have lowered their interest rates making it easier to borrow currency to make a carry trade.