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TE06 - Carry Trade Criteria and Risk

"A currency carry trade strategy might seem sophisticated. This is because many large institutional players often tend to take advantage of the economic and monetary policy conditions. For the retail forex trader, a currency carry trade strategy might seem like an alternative approach to regular technical analysis. But to be adept and to make a profit from currency carry trade, traders should focus on a lot of aspects. It is not just technical analysis but also fundamental analysis that plays a big role in your success in currency carry trade. In this article, we explore the criteria and the risks for a currency carry trade strategy. The approach in this method of trading is entirely different and therefore it is not recommended for all traders. Typically, you will find currency carry trade being explained as simply buying one currency with higher interest rate and selling another currency with lower interest rate. But there is more to that."

Carry trade strategy is something that doesn’t occur all the time. The current economic conditions play a big role. For example, during the 2008 global financial crisis, the monetary policy across the globe was dovish.

This led many central banks to lower interest rates, save for a few. Under these circumstances, carry trade strategy was possible.

But since the 2008 financial crisis, the markets have evolved significantly. Now a days it is not quite easy to attempt a currency carry trade strategy. If your sole purpose of a currency carry trade strategy is to buy and hold a currency pair and gain from the overnight swap rates, then you should think again.

Besides the criteria, there are also some risks involved which can make your carry trade strategy worthless.

You should also look at how much of profits your carry trade strategy can make for you. This depends of course on the total number of units or lots that you are holding. If you are thinking about trading in micro or mini lots and expect to make money from a currency carry trade strategy, you wouldn’t get too far.

Typically, currency carry trade strategy is something that is more beneficial for high net worth investors. In these cases, the minimum amount of investment can be at a few millions if not more.

Therefore, for the average retail trader, a currency carry trade strategy will not give much benefits.

But having said that, you could look at some currency pairs that could yield positive swaps. Then, based on the technical analysis you could look for the buy signal to be generated such that you profit not just from the exchange rate fluctuation but also the positive overnight swaps.

What are the risks of currency carry trade strategy?

When looking at a carry trade strategy, traders should also consider the risks involved. While there are number of risks involved, we can primarily categorize them into one of the following:

Currency exchange rate risk

The currency exchange rate risk is something that one should consider. Regardless of whether you are holding a long or a short position, the exchange rate fluctuation can easily eat into your profits.

For example, if you were long on a currency that yields higher interest rate and short on a currency that yields lower interest rates, the currency pair should ideally behave accordingly. Based on the above example, if you were holding a long position on a currency pair, besides the interest rate differential that is paid, the currency pair should also appreciate.

While the general norm is that for a currency with a higher yielding interest rate to appreciate, this is not always the case. If the exchange rate moves against your position, you could end up making a significant loss.

Changing monetary policy

Monetary policy is something that trader should pay attention to as well. It is not all the time that the interest rates will remain the same. Since you are looking at two different central banks, as defined by the currency pair, you should pay attention to the respective economies as well.

Although interest rates do not change overnight, the developing conditions in the markets could potentially shift the bias. Thus, you could expect to see the central bank either moving from hawkish to dovish or vice versa.

Charges and fees

If you are looking at the currency carry trade from a forex trading perspective, then you would most likely be looking at holding your positions over long periods of time. This can come with risks as well.

For example, your broker might charge you fees or other charges that could eat into your positions. Also, not all brokers pay out the correct interest rate differentials. Therefore, you should first check on the overnight swap fees that are charged by the broker before trying to attempt a carry trade strategy.

Can you make big profits using a currency carry trade strategy?

That is one question many traders tend to ask. However, this depends on the various criterion as well as keeping an eye on the ever changing risks. For the most part, traders can profit from the positive interest rate differential.

This again depends on whether you are long or short on the currency pair of interest. Bear in mind that currency carry trade is primarily used for funding purposes and is used by large institutional investors.

Therefore, traders should get their expectations right when it comes to using a currency carry trade strategy and expecting to make money off it.

Read 940 times Last modified on Friday, 26 July 2019 17:17