Carry Trading – What is it,  Advantages and More

The carry trade, or financial bicycle, is a trading strategy based on purchasing and selling currencies to obtain profits. Using the differences between the interest rates of the different Central Banks.

The carry trade is a widely used strategy in the Forex or foreign exchange market. In practice, investors sell a currency t with a lower interest rate to buy one with a higher interest rate. In this way, it finances with the currency money offers less interest. The investment in currency money provides a higher return due to the differences between interest rates.

What is Carry Trading?

A Carry Trade is a trading policy to borrow at a low interior-interest investment in an advanced interest-rate asset. In other words, a carry trade is, utmost of the time, based on a loan in one money with a low-interest rate and the conversion of the lent amount into another currency. And of course, this technique can be used on stocks, supplies, real estate, and bonds denominated in the second currency.

And like any trading strategy, the Carry Trade strategy also has pros and cons:

Contras

• There is a risk of a sharp currency exchange decline, which will probably kill the profit.
• The same with invested assets – they can change in price and lower the rental value.
• Hedging is an option, but not very advantageous, as the money spent on ensuring losses will cover the profits made by traders from the difference in interest rates.
• This trading strategy can create a financial bubble.

Advantages of Carry Trading

• One of the advantages of the carry trade is that a trader could profit from the difference in interest rates on positions held overnight, in addition to any appreciation in the market trades.

For Forex traders, the most significant advantage is the use of leverage. Which can benefit from the interest rate spread on the total value of their position rather than just the money in the margin to open the trade.

Disadvantages of Carry Trading

• However, this is also a drawback of Forex carry trading, as leverage can also mean higher losses.
• Another drawback of the carry trade is that currencies can be volatile, and interest rates change over time. It means that the trader must keep up with new Central Bank actions and conduct research to find markets that offer a positive carry trade but also provide a positive return on their investment. As continuously, risk management is key to managing your capital.

Example of carry Trading

To finish understanding the carry trade, let’s see it with an example!

Imagine that we see that the interest rate in Japan, which stands at 0.50%, has a meagre financing cost, with which we can make investments in currencies from other places where the interest rate is higher.

As before, let us imagine analysing other economies. We observe that the Euro Zone and US rates stand at 3.75% and 5.25%, respectively.

Using the low interest of the yen, we can finance ourselves by investing in dollars or euros. In addition, in this way, as we said before, we are saying that the euro or the dollar will appreciate because that is why we invest in it.

What risks does Carry Trading have?

The carry trade is a strategy that the best investors in the world in the foreign exchange market have ever used. But it must be thought that, like everything in the investment world. It is not without risks that could lead us to lose that benefit. That, a priori, we contemplated the acquisition.

Let us imagine that in that hypothetical operation we have indicated in the example, the exchange rate collapses after a year due to an unexpected situation that, like the 2020 pandemic, causes a sharp dollar depreciation.

In this scenario, depreciation would cause losses that, in extreme and exceptional cases, could lead us to lose all our money and even to bankruptcy if we were highly leveraged.

For this reason, we speak of a helpful strategy if it goes well. But with a clear risk that we must contemplate.

So when to enter a Carry Trade and when to exit?

The best time to use the carry trading strategy is when banks are thinking or interest rates are rising – many people are starting to buy currency, thus pushing up the currency pair’s value. As long as the worth of the coin does not fall, traders will manage to make a profit.

The worst time to use the carry trading strategy is during the interest rate reduction period. The change in monetary policy also means a change in currency values. When rates fall, the demand for the currency also tends to decrease. For the Carry Trade strategy to result in a profit, there has to be some degree of an interest rate increase or no movement.

Conclusion

The bottom line is that the carry trading strategy is profitable, especially when using leverage. Which is relatively simple and risky. To beat that trader, you have to implement proper risk management. The trader must know when to enter a Carry Trade and exit. And the most crucial part is that before using this type of risky s, strategy, you have the skill and experience.