What is a Carry Trade in Forex Trading?

by Andrew McGuinness     Jul 16, 2019

If you've spent any time reading about Forex trading online, there's no doubt that you've already heard the phrase "carry trade" before. By learning more about carry trades and understanding when they are useful on the Forex market before you begin trading, you'll be better prepared to effectively trade on the Forex market.

Every country in the world has an interest rate attached to it. The interest rate is determined by the central bank of the country, and largely depends upon how in-demand the currency is considered. During a carry trade, traders sell a currency that has a low interest value, and uses the proceeds to purchase a currency that holds a much higher interest rate. The result is a gain in the spread of the interest rates; this is referred to as an "interest rate differential." The best carry traders don't just purchase a currency that carries a higher than average interest rate; they also strategize ahead of time and purchase a currency that they believe will increase in value over time as well. That way, the trader makes potentially double the money that they would have on a standard trade. In other words, the most important thing when considering whether or not a carry trade is worth pursuing is not the absolute value of the difference in interest rates, but the direction of the spread. Smart traders think about thier carry trades in the long term, and know that the best moves to make when Forex trading is to perform a carry trade that will result in them holding a currency that is likely to increase in value over time. The best carry trades are made in the proper direction, and end with the Forex trading professional holding a currency that will increase in both interest value and trading power over time. This leaves the trader in a very powerful position, and requires quite a bit of political and economic research to predict exactly on the nose.

A large percentage of predicting how successful a carry trade will be is the amount of leverage that you are able to wield while trading. Leverage is what makes it possible for individual traders who are not parts of a government or international corporation to start Forex trading. The average trade on the Forex market is called a "lot," and is valued at $100,000; far more than the average investor has on-hand in liquid assets to risk while forex trading. For the longest time, this simply meant that Forex investors had to put up a minimum of $100,000 to start trading, which limited the market largely to institutional investors. Now, brokers allow individual traders to trade on a margin, allowing them to "borrow" money to trade, called leverage. The average leverage is 100:1, meaning that for every $1 you put into your account, you can trade with $100 on the Forex trading market. This means that a seven percent increase in value or a seven percent interest spread can become seventy percent, a much larger and more profitable margin.

The bottom line? The smartest carry trades look for a currency pair with a large interest spread and an increasing value or increasing interest spread. These make the most profitable pairs, and any trader can find them by doing the right research.

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