With interest rates dictating the rate of return for holding assets denominated in the local currency, forex traders also pay special attention to interest rate differences when it comes to keeping their positions open for a long time. This is because the interest rate difference is carried on when a forex position is kept open overnight. This practice is known as carry trade.The carry trade is often referred to in forex circles and it is a technique smart traders use to profit, not just from movement in a currency but from the interest rate differential between two countries.
A carry trade is a currency trade in which low-yielding currencies are borrowed and high-yielding currencies are lent. A trader uses this strategy to benefit from the difference between the interest rates. The level of profits made from the trade depends on the difference in interest rates and the amount of leverage used by the investor. Currency carry trade correlates with the stability of the global financial and exchange rate.
The benefits of this type of trading are pretty obvious. By trading in the direction of positive interest, you would collect a premium payment every day. This would pad your bottom line profit over and over again. Forex trading can be done with leverage, so your actual return on capital is amplified. However, if the tree starts to go against you and you are using leverage the amount of rollover you collect on a daily basis is likely not making up for the profit decline of the actual trade.
The key to a successful carry trade is not just trading a currency with high interest rate and another with a low interest rate. Rather, more important than the absolute spread between the currencies is the direction of the spread. For an ideal carry trade, you should be long a currency with an interest rate that is in the process of expanding against a currency with a stationary or contracting interest rate. This dynamic can be true if the central bank of the country in which you are long is looking to raise interest rates or if the central bank of the country in which you are short is looking to lower interest rates.
We should keep in mind that while executing the carry trade setup, we have to be selective and do a thorough analysis to ensure that we are choosing only the highest probability carry trade setups. This entails studying the current economic conditions in the countries we are interested in, and applying additional fundamental and technical analysis methods as well. The carry trade is not for the very short term trader, but instead should be used as a longer term trade approach.