What is a carry trade?

Carry Trade: A Simple Strategy for Long-Term Forex Earnings

Carry trade is one of the simplest and most fundamental strategies for long-term trading. It is based on the interest rate differential between currencies, allowing traders to earn stable returns without resorting to complex technical analysis methods. While this strategy cannot be classified as high-yield or universal, its stability and relative safety appeal to both novice traders and large investors willing to allocate significant funds to long-term trades.

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The Principles of Carry Trade: How It Works

Carry trade involves taking a position in a currency with a low interest rate (typically as a loan) to invest in a currency with a higher interest rate. The interest rate differential, known as the swap, becomes the primary source of income for this strategy.

Interest Rates as the Main Indicator

Interest rates represent the cost of money in an economy as set by the central bank. They influence market behavior and reflect economic conditions:

1. High Interest Rates:

   • Indicate a tightening of monetary policy to prevent economic overheating.
   • Strengthen the national currency, making it more attractive to investors.

2. Low Interest Rates:

   • Lower borrowing costs, stimulating economic growth.
   • Weaken the national currency.

Example:
The Federal Reserve's cycle of rate hikes significantly strengthened the U.S. dollar, making it an attractive asset for investors.

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How to Select Currency Pairs for Carry Trade

1. Currency with High or Rising Interest Rates

Look for currencies where interest rates are already high or are expected to increase. This makes them more attractive to investors, leading to currency appreciation.

Example:

• USD/JPY: The U.S. dollar with rising rates against the Japanese yen with zero or negative rates.

2. Currency with Low Interest Rates

Currencies with low interest rates, such as the Japanese yen, Swiss franc, or euro, are often used as "funding currencies" in carry trades. Their weakness allows traders to profit from the rate differential.

Example:

• EUR/AUD: The euro with low rates versus the Australian dollar, known for its high interest rates.

3. Analyze Charts

Examine weekly and daily charts for your chosen currency pair. Ensure the trend supports the carry trade strategy, and confirm key levels for entry.

4. Check Swap Rates with Your Broker

Verify the size of the positive swap for your selected currency pair. This figure can vary depending on broker conditions and liquidity providers.

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Risks of Carry Trade and How to Mitigate Them

Despite its simplicity, carry trade comes with certain risks that must be addressed:

1. High Leverage on Deposits

Using excessive leverage to boost returns can lead to significant losses during sharp market movements.

• How to Mitigate Risk: Use a small portion of your deposit for trades and always apply stop-loss orders.

2. Ignoring Macroeconomic Factors

High interest rates do not always guarantee success. Geopolitical events, crises, or negative economic data can devalue even currencies with attractive rates.

• How to Avoid This: Analyze not just interest rates but also macroeconomic indicators like inflation, GDP, and labor market conditions.

3. Influence of Other Markets

Certain currencies, such as the Canadian dollar (CAD), depend heavily on commodity markets. For example, a drop in oil prices can weaken the CAD despite high interest rates.

• How to Mitigate Risk: Avoid trading pairs tied to volatile markets unless you fully understand the underlying dynamics.

4. Risks of Position Rollover

Carrying positions over weekends or holidays can result in increased swaps or sudden price gaps.

• How to Mitigate Risk: Monitor economic calendars and avoid holding positions during periods of high uncertainty.

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Advantages and Disadvantages of the Strategy

Advantages:

1. Stable Income: Consistent accrual of swaps with long-term position holding.
2. Simplicity: Does not require advanced technical analysis.
3. Suitable for Large Investors: Significant capital amplifies returns.

Disadvantages:

1. Low Returns: Not ideal for traders seeking quick profits.
2. Long Implementation Period: Noticeable profits take months or even years to materialize.
3. Market Dependency: Changes in interest rates or external shocks can disrupt expectations.

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Conclusion: Who Is Carry Trade Suitable For?

Carry trade is an ideal strategy for traders prepared for long-term investments, patient enough to wait for results, and equipped with sufficient capital to minimize risks. It provides stable, albeit modest, returns, making it appealing to large investors and institutional players.

However, success in carry trade requires not only an understanding of interest rates but also an analysis of macroeconomic factors, risk management, and disciplined capital allocation. If you are ready for a patient and disciplined approach, this strategy can become a reliable tool for building consistent income.

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Effectiveness of the Strategy and Its Relevance

Despite its appeal to long-term investors, carry trade has lost some of its popularity in recent years. The primary reason is the strategy’s low profitability in today’s market environment.

Why Has Carry Trade Effectiveness Declined?

1. Decline in Interest Rates:

   • Following the 2008 global financial crisis, many central banks adopted low or even negative interest rate policies. This significantly reduced the rate differential between currencies, making carry trade less profitable.

2. Increased Uncertainty:

   • Economic and geopolitical crises, such as the COVID-19 pandemic, rising inflation, and geopolitical conflicts, have heightened market risks. Investors now prefer safer assets, reducing carry trade’s attractiveness.

3. Low Returns:

   • Even under ideal conditions, carry trade offers relatively modest profits. Achieving substantial returns requires large capital and long-term positions, making the strategy less appealing to most traders.

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Academy’s Position: Carry Trade as a Learning Tool

Within our academy, carry trade is primarily viewed as an educational example to help students understand the fundamentals of interest rates, macroeconomic indicators, and long-term strategies.

We do not recommend relying solely on carry trade as your primary trading or investment approach. Instead, we encourage integrating this strategy into a diversified portfolio, combining it with other methods such as technical analysis, fundamental analysis, and short-term strategies.

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Conclusion: A Realistic View of Carry Trade

Carry trade is not the "holy grail" of trading. In today’s market conditions, its effectiveness is limited, and significant capital is required to achieve noticeable returns.

However, studying this strategy provides traders with valuable knowledge about how interest rates work, how economic conditions influence currencies, and how to manage risks in long-term trading.

 

Success in financial markets requires flexibility, the use of diverse approaches, and readiness to adapt to changes. Carry trade is just one of many strategies that should be considered as part of a comprehensive approach to trading and investment.