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Forex is a gigantic market with trades worth more than $4 trillion occurring every working day. While most people rely on buying currencies at a lower price and selling them at a higher price to earn profits, there are various other ways of making handsome gains as well. One needs to be flexible and creative in his or her trading approach to utilize these ways. These alternatives not only provide a flexible way of earning money but also allow easier trading opportunities since no technical analysis is usually involved. Carry trading is among most popular trading strategies in this regard.
Basically, traders rely on the difference between interest rates in two different currencies in this particular forex trading strategy. At its core, it involves practice of borrowing money in currency which has lower interest rates and then using this money to buy currency with higher rates of interests and investing this money to earn this higher interest. If done right, substantial profits can be earned in the form of the difference between the interest rates of the two currencies. However, this is just one way of earning profits with carry strategy. Most traders focus on currencies whose value is expected to appreciate in future. Hence, the appreciation in currency value also results in capital gains for traders. It should be remembered here that this strategy is usually profitable in the long run and may not be adequate for short term investments. Consider the following simple example to understand how carry trading works.
Suppose that interest rate of Japanese Yen (JPY) is 1.2%. However, the same interest rate for American Dollar (USD) is 2.5%. A trader relying on carry trading strategy should borrow Japanese Yen from a bank and use this amount to buy American Dollars. Now the trader can invest these American dollars to earn interest. Basically, the trader will be earning 2.5% on the amount invested but will need to pay only 1.2% on the amount borrowed. Hence, the net profit is 1.3% of the borrowed amount. Moreover, considerable capital gains can be ensured if the United States Dollar appreciates in its value in the future.
Carry trading has become very popular recently due to various benefits it provides. Firstly, as mentioned above, it provides two sources of profits. It allows a brilliant opportunity to earn regular income in the form of the difference between two interest rates as well as an opportunity to earn capital gains. It is obviously not a straightforward task to pick the relevant currencies; however, the analytical process involved is simpler and easier than that involved in traditional forex trading. Moreover, carry trading provides much stronger probability of earning substantial profits than most other forex trading strategies. Last but not the least; this particular trading strategy is also less risker since most interest rates do not substantially fluctuate.
As mentioned above, the analytical and technical process involved before choosing trades is much easier in this strategy. However, it does not mean that a trader can trade without any preparation. Successful carry trading involves considerable amount of research, a focused approach and analysis of the previous data. The most important thing is to find a high rate differential. Your trade is as good as your choice of the currency. Recently, many investors have been relying on Swiss Franc (CHF) and Japanese Yen (JPY) due to low interest rates and American Dollar (USD) and Australian Dollar (AUD) for earning higher interest rate by investing in these currencies.
It is also important to mention here that carry trading is not risk free, just like any other trading strategy. There is always a risk of unfavorable price movements of forex currencies and the loss due to this movement can negate any profit earned due to difference in interest rates. However, these risks are much lower if you choose currencies after careful analysis and logical reasoning. Furthermore, these risks can be mitigated by using different hedging strategies, such as future or options.
Furthermore, amateur investors should be proactive in their approach in order to save themselves from negative carry trading as wrongly chosen currencies can result in lower interest rate from investment as compared with the interest rate of borrowing.