While you are paying the low interest rate on the financial instrument you borrowed/sold, you are collecting higher interest on the financial instrument you purchased. Your profit is the money you collect from the interest rate differential.
This is another way to make money in the forex market without having to buy low and sell high, which can be pretty tough to do day after day.
Carry trades work best when investors feel like taking on risk. Current economic conditions need not be good, but the outlook does need to be positive.
If a country’s economic prospects aren’t looking too good, then nobody will be prepared to take on the risk. To put it simply, carry trades work best when investors have low risk aversion.
Carry trades do not work well when risk aversion is high.
When risk aversion is high, investors are less likely to buy higher-yielding currencies or likely to reduce their positions in higher-yielding currencies.
When economic conditions are uncertain, investors tend to put their investments in safe haven currencies, which tend to offer low interest rates like the U.S. dollar and the Japanese yen.
It’s pretty simple to find a suitable pair to do a carry trade. Look for two things:
- Find a high interest differential.
- Find a pair that has been stable or in an uptrend in favor of the higher-yielding currency. This gives you the ability to stay in the trade AS LONG AS POSSIBLE and profit off the interest rate differential.
Always remember that economic and political factors are changing the world daily. Interest rates and interest rate differentials between currencies may change as well, bringing popular carry trades (such as the yen carry trade) out of favor with investors. So when doing a carry trade, you should still limit your losses like a regular directional trade.
When properly applied, the carry trade can add significant income to your account, along with your directional trading strategies.