In forex markets, carry trading is an easy way to take benefit of the basic economic principle that money is constantly flowing in and out of different markets. Markets with a high rate of return will generally attract more capital.
Carry trading is a popular trading strategy employed by professional forex traders. Hedge funds and investment banks use leveraged carry trading as one of the favorite strategies. Retail forex traders can also benefit from carry trading.
What is a carry trade? In nutshell, carry trading means taking advantage of interest rate difference between two currencies in a currency pair. Investors take benefit of the interest rate differential between two currencies by going long/buying the high interest rate currency and going short/selling the low interest rate currency.
Lets use a simple example to make it clearer: lets assume, New Zealand dollar is offering an interest rate of 4.75% whereas the Japanese yen is offering an interest rate of 0.25%.
In order to carry trade, an investor buys New Zealand dollars (NZD) and sells Japanese Yens (JPY). As long as the exchange rate between the NZD and JPY does not change, the investor will earn a profit of 4.75-0.25=4.5%. Using a leverage of 5:1, this 4.5% return will be leveraged into 22.5%.
If the currency pair NZD/JPY appreciates, the investor can get a capital gain as well as a yield on the investment. When there is a carry trade opportunity, many investors jump on the bandwagon. The more investors carry trade, the more the currency pair appreciates.
It depends a lot on the mood of the investors as a group. If investors as a group have low risk aversion, carry trading will be profitable. But if the investors as a group suddenly develops high risk aversion, carry trading will become unprofitable.
By entering into a carry trade, an investor expects to profit from an interest rate differential between the two currencies. But if the low interest rate currency appreciates considerably for some reason or another, carry trade will become unprofitable.
How do you check the mood of the investors? By knowing whether the currency is overbought or oversold. For this you need to identify the current trend of the currency pair and see whether it is moving in the right direction!
MACD (moving average convergence divergence) indicator can help you in this regard. You should enter the trade when MACD crosses the zero line from below. You should exit the trade when it crosses the zero line from above.
