Which is the forex strategy equally popular with both institutional, professional traders, and retail forex clients? The carry trade…which is a highly successful, albeit often risky strategy that combines fundamental and technical analysis into a long term strategy.
The carry of anything is the opportunity cost of holding it. For example, a gold bar has negative carry because the only return is the cost of storing it (in a bank safe). The carry of a currency is the interest income generated. In the carry trade, traders create various strategies to exploit the interest rate gap between the currencies bought and sold in order to make a profit, hence the name of the practice.
What happens when we buy a pair of EURUSD? We purchase one lot of Euros, sell one lot of American dollars. The transaction is in the spot market, so it should be settled at the end of the day, with no positions hanging over to the following period. When, however, a trader decides that he desires to hold the position for a longer period of time, the broker will do a rollover of the position by paying to the bank interest on the sold (and borrowed) currency, and receiving interest income on the currency that is bought. In our case, we would receive interest on the Euros purchased during the transaction, while paying interest on the dollars that we had sold. We would receive the carry of the two assets that we hold.
The carry trade becomes profitable when this interest rate differential is positive (our account accumulates interest income over time), but in an unleveraged account the carry is so small that only years of holding it would equate to the sizeable turns sometimes exceeding a yearly thirty percent boasted by traders. So carry trade is a leveraged, directional trade.
The fundamental strength of the carry trade is the result of the fact that a high interest rate paying nation must have a dynamic economy in order to be able to meet its external obligations. Barring some unusual cases, such an economy tends to attract institutional investors and professional speculators, leading to large capital flows that appreciate its currency and maintain it at a high level. The flipside is that these flows are, for the most part, dependent on the promise of high yield, and their withdrawal can lead to crises in the host nation. Of course, this risk comes with profit opportunities, and that’s why the carry trade is so popular.
The best way of making use of this strategy is combining it with a long term view, where lower leverage can be justified by a longer commitment term. Also, if you want to try this strategy, bear in mind the high susceptibility of the carry trade to adverse events. Markets are prone to punishing carry traders severely in response to turmoil, and it is not unusual to see the gains of an entire year wiped out in the course of hours on an exceptionally bad trading day.
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