It is a type of trading in which a trader sells a certain currency with a low interest rate and then uses it to purchase another currency that yields higher interest. The main goal of a carry trader is to capture the existing divergence in interest rates and earn substantial profits with help of leverage.
Assume you notice that interest rates in South Africa are 7%, while the current interest rates in the US are 1%. So, you expect to earn 6% difference between the two rates. For this to happen, you should borrow USD (the low-yielding currency, the issuer of which set a relatively low interest rate), and buy a higher-yielding currency, in our example it is South African Rand. You may increase the amounts of money you earned using leverage. For example, if you use a standard 10:1 leverage ratio you can earn a profit of 60%. But there is a big risk behind this – the unpredictability of exchange rates. If the ZAR was to drop against the USD, you would lose a great part of your return.
So, although carry trades look very attractive, they are quite risky especially in troublesome, uncertain times when investors tend to rush into low-yielding safe-havens neglecting risky financial assets, which offer higher returns.
Profits earned through the carry trade may not be a primary goal of the trader, they could be a good addition to the gains he/she earns on price fluctuations.
Example of a trader
Julian Robertson is one of the most famous carry traders the history knows. He used to trade USD/JPY. In the period between 1995 and 1998, this currency pair appreciated more than 66%, in part thanks to carry traders buying high-yielding currencies and selling the yen. The trader could make 15% profits on the interest rate differentials adding to 66% he gained on the surge in USD/JPY. Julian Robertson was trading USD/JPY with leverage and earned lots of money in that period, although after the 1998 sudden appreciation of the yen, he lost $2 billion.
Other articles in this section
- How to deal with market noise?
- How to backtest a trading strategy
- Gator Oscillator
- Market Facilitation Index
- Accelerator Oscillator
- Awesome Oscillator
- Bill Williams theory
- Chart patterns
- Uncovering Gann indicators
- How to create your own trading strategy?
- Candlestick patterns
- Trend trading
- Swing trading
- Position trading
- Day trading
- Trading styles and strategies
- Fibonacci tools
- Trader's psychology
- Identifying market’s reversal
- Japanese Candlesticks
- Market conditions: trends and ranges