Forex Carry Trades: Pushing The Odds In Your Favor
Currency trading is an area in finance and investing that continues to get more attention as the technology changes and improves to allow anyone to take advantage of currency markets. There is no market quite like the Forex as leverage allows traders with even just a couple thousand dollars to have control over hundreds of thousands of dollars when trading. The far majority of trading is done between 8 major currencies, and even among those there are four currency pairs that are considered the major bread and butter combinations that account for the majority of the total trading done even among those currencies, as well.
However, the volatility of the markets make currency trading a high risk proposition. This means traders need to do their research, figure out how to master pattern recognition, and use every advantage they have in order to push the odds further into their favor. This is where the carry trade often comes into play – especially if you’re trading currencies with vastly different interest rates.
What Is A Carry Trade?
There are certain currencies that are renowned for having extremely low interest rates (Japan always, the United States in recent years) and then other ones that are known for having a much higher interest rate than is standard (NZD & AUD are prime examples of this). So what happens if you trade a currency pair like AUD/JPY where one tends to have a large interest rate and the other a really low one?
The interest rates on the leveraged currency is figured up at the end of day for those particular trading markets and credited to the account. So if Australia is at 5.75% and Japan’s Yen at 0.25%, then the result is 5.5%. That interest (annually) is split up and applied to the leveraged currency being traded, meaning free pips into the trader’s account as long as they take the long position.
Forex traders loved this for more than one reason.
Benefits Of Carry Trade
There are two major ways the carry trade helped Forex traders earn profits. Aside from the obvious benefit of providing additional pips, carry trades could function in one of two major ways. The first is as a built in safety net. When the interest rates have a wide spread, trades that would end with minus two pips or minus 6 pips suddenly might become profits depending on the amount of positive interest that is applied to the account. Considering how small a pip is, a few dollars of interest can have a major effect on helping swing more “break evens” into “minor wins.”
The other way this benefit helps beyond the safety net is compounding a winning trade. Small wins become moderate, moderate wins become larger ones, and the interest can add up extremely quickly especially for traders who engage in hundreds of trades over the course of a year.
Bigger Variance Equals More Opportunity
While having Australia at 4.5% and plenty of nations at 1% or under does offer opportunities, when there is an especially wide spread like Australia and New Zealand at 9%, Japan at under 1%, and various currencies all up and down the spectrum, there are also more opportunities between multiple currencies so if the AUD takes a tumble there are still other opportunities to use interest rates to your advantage.
While there’s a lot of focus on things like scalping and quick turnarounds in day trading, these don’t hold a candle to the long term profit potential that comes from fully understanding how interest rates work when trading currencies. Take the long position and take advantage of what the markets have to offer you!