Another popular trading strategy among currency traders is the carry trade. The carry trade is a strategy in which traders borrow a currency that has a low interest rate and use the funds to buy a different currency that is paying a higher interest rate. The traders' goal in this strategy is to earn not only the interest rate differential between the two currencies, but to also look for the currency they purchased to appreciate.

Carry Trade Success

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. There have been plenty of opportunities for big profits in the past in the carry trade. Let's take a look at a few historical examples. (To learn more, read Currency Carry Trades Deliver)

For much of the time betweeen November 2015 and November 2016, the AUD/CAD currency pair offered a positive yield spread of at least 1%. Using the 1% as an example, which may appear small, with the use of 10:1 leverage the return would become 10%. During that same period, the Australian dollar also appreciated from 93 cents to close at 1.025 against the U.S. dollar, which represented a touch more than 10% appreciation in the currency pair. This means that if you were in this trade you would have profited from both the positive yield and the capital gains.

 

Conclusion

The main thing to look for when looking to do a carry trade is finding a currency pair with a high interest spread and finding a pair that has been appreciating or is in an uptrend. With the moves by most central banks to lower interests toward zero in an attempt to stimulate their economies, overall interest in the carry trade has also decline. However, understanding the underlying fundamentals behind interest rates changes is one of the keys to implementing a carry trade and is needed for when the strategy moves back into favor. The next section will introduce you to the all-important concept of money management within your forex account. (If you require a refresher on interest rates, go back to section 5.3 on interest rates or refer to Trying To Predict Interest Rates)

Money Management

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