So, what is this mysterious, ominous activity that can make you rich or poor on the whim of some national bank? Carry trade stands for borrowing a currency with a low yield to buy another one with a high yield. For example, when you enter a USD/JPY currency pair, you’re basically borrowing Japanese yens to buy US dollars. You’re considered debtor for the amount of JPY you borrowed and the owner of the amount of US dollars you’ve purchased for the duration of a trade.
Carry trade is only possible when your position remains open overnight. Of course, having a position for one night won’t give you much, so carry trading usually goes on for months or even years if the market allows it. And for all the time while your trade is open, you have to pay interest rates for borrowing JPY, and you’re going to earn the interest rates for your USD. And the difference between those is going to make your profit. Suppose the annual interest rate for borrowing Japanese yens is 0.5%, and the annual interest rate for depositing USD is 4%. In that case, your annual yield is going to be 3.5% if both currencies remain perfectly stable.
That’s how the carry trade works, in a nutshell. But it would’ve been too easy, and everyone would’ve used it if that was all there is to it. So what are the drawbacks?
Factors to Consider When Carry Trading on Forex
In the carry trade, your main source of income is the yield, and you’re generally not very interested in the currency movement. For all you care, the pair can stay perfectly still, and you’ll earn your money waiting, which is a perfect scenario for carry traders. Yet if the funding currency is getting stronger - you’ll start losing money even more so if you’re using substantial leverage. In this case, your capital might diminish very quickly.
Sometimes national banks can spoil all the fun for you. If you’ve read other articles about the carry trade, you might’ve noticed that JPY is always the funding currency, and there’s a reason for that. The Bank of Japan keeps the interest rates ridiculously low to help boost the national economy, thus enabling carry traders to profit. Tens of thousands of major and minor traders are selling JPY and buying other currencies, slowly driving the JPY exchange rate down, and when it gets too low - the Bank of Japan will intervene and put the rates higher. When the rates get higher, carry traders will unwind, buy JPY and stabilize its value, and then the circle continues.
To sum it up - you have to stay on top of the wave if you want to profit from the carry trade. In this case, you should read all the announcements of the national banks of all currencies in your portfolio. And if you’ve done everything correctly - you’re going to profit a bit slower than with day trading, but your income is going to be stable.