Let’s go over the requirements for a carry transaction.
Finding a suitable pair for a carry trade is relatively straightforward. Keep an eye out for two things:
- 1. Look for a large interest differential.
- 2. Look for a pair that has been steady or rising in favor of the higher-yielding currency. This allows you to remain in the trade for AS LONG AS POSSIBLE and benefit from the interest rate differential.
Isn’t it simple?
Consider the following real-world illustration of the carry trade in action:
This is a AUD/JPY monthly chart. During this period, the Bank of Japan maintained a “Zero Interest Rate Policy,” with a near-zero interest rate of 0.10%.
ZIRP is another name for it.
With the Reserve Bank of Australia touting one of the main currencies’ highest interest rates (4.50% in the chart example), many traders flocked to this pair (one of the factors creating a nice little uptrend in the pair).
From the start of 2009 to early 2010, this pair went from a price of 55.50 to 88.00.
That’s a total of 3,250 coins!
When combined with interest payments from the two currencies’ interest rate differentials, this pair has been a good long-term bet for many investors and traders who can weather the volatile up and down movements of the currency market.
Of course, economic and political variables change on a daily basis.
Interest rates and interest rate differentials between currencies may also change, making famous carry trades (such as the yen carry trade) less appealing to investors.
Carry Trade Risk
You already know what the first question you should ask before making a trade because you are a very smart trader, right?
“How much risk am I taking?”
Correct! Before entering a trade, ALWAYS consider your maximum risk and whether it is acceptable according to your risk management guidelines.
Joe the Newbie Forex Trader’s maximum risk in the example at the outset of the lesson would have been $9,000. When his losses reached $9,000, his position would be immediately closed out.
That doesn’t sound very appealing, does it?
Remember, this is the worst-case situation, and Joe is new to trading, so he hasn’t fully recognized the importance of stop losses.
Carry trades, like normal directional trades, allow you to limit your losses.
For example, if Joe chose to limit his risk to $1,000, he could place a stop order to close his position at whatever the price level would be for that $1,000 loss.
He would continue to keep any interest payments he got while having the position.