A carry trade is when you buy a high interest currency against a low interest currency. For each day that you hold that trade your broker will pay you the interest difference between the two currencies as long as you are trading in the interest positive direction. For example, if the (EUR) has a 0.15 percent interest rate and the (USD) has a 0.25 percent interest rate, and you go long on the EUR/USD you are making a carry trade. For every day that you have that trade on the market the broker is going to pay you the difference between the interest rates of those two currencies which would be 0.10 percent.
Forex carry trading is not as exciting as day trading, but it can be an excellent addition to your forex trading plan. The carry trade is a powerful set up where a trader looks to gain not only on the profit or loss of the pair going in the direction of the trend, but a strategy that allows you to collect interest payments. You can collect interest daily if you buy the higher yielding currency and sell the lower yielding currency. This presents a unique opportunity in forex trading that in the current low interest rate environment is best found in exotic pairs.
If you make an interest positive trade on a currency pair that pays high interest and the exchange rate stays the same or moves in your favor you are a big earner. If the trade moves against you the losses could be substantial. The daily interest payment to your account will lessen your risk but it is not likely that it will be enough to really protect you from your trading loss. Carry interest should be viewed as “icing on the cake” rather than just an easy “no brainer” strategy.
There is a fair amount of risk to the carry trading strategy. The currency pairs that have the best conditions for using the carry trading method tend to be very volatile. For this reason carry trading must be conducted with caution. Unstable markets can have a fast and heavy effect on currency pairs that are considered to be “carry pairs” and without proper risk management traders can be drained by a surprising and brutal turn.
A trader should be able to understand the underlying fundamentals behind the interest rate changes. This can be known after thorough economic analysis of both countries where the currencies are from. The currency which comes from the country that faces inflationary pressure in the economy wherein the central bank looks for an interest rate hike needs to be bought. The currency which comes from the country that faces little inflationary pressure as compared to the need of increasing money supply in the economy in order to bolster growth needs to be sold.