What are carry trades?
Carry trade is borrowing or selling a financial instrument with a low interest rate and then buying another financial instrument with a higher interest rate. Thus, the investor earns money from the interest rate differential. The investor pays for a low-interest rate for one financial instrument while collecting a high interest from the other financial interest rate. Today’s topic will cover one or a few things about carry trades’ criteria and risks.
First, we have the criteria.
To know whether a currency pair is suitable for a carry trade or not, first, look for a high-interest rate differential. Next, look for a stable currency pair or one that is in an uptrend that sides with the higher-yielding currency. You are looking for this because you want to stay in that trade as long as possible. The longer you are in the trade, the more profits you can collect from the interest rate differential.
Let us cite a famous example.
Bank of Japan has a zero interest rate policy, also known as ZIRP. The interest rate is called as such because its 0.10% rate is nearly zero. On the other hand, the bank of Australia has one of the highest, if not the highest, interest rates against other major currencies. For instance, the interest rate is 4.50%. As a result, it catches many traders’ attention.
So, in a sense, it would be a nice idea to borrow from Japan and then buy from Australia, right? The interest rate differential is significant between the two currencies. However, there are always uncertainties. For example, there are economic and political factors that we have to consider daily. Also, interest rate differentials and interest rates do not always stay the same. So, there is also a possibility that odds will not always be in the investor’s favor.
Next, there are also posing risks.
Any trade poses a risk. A wise trader will always make sure that the trade is worth it before entering. A smart trader knows how to weigh both circumstances and knows what to do if worse comes to worst. What will you do if you are in this kind of situation?
Here is what you can do:
Let us assume that Archie is new in trading. He has not made many trades yet, so his maximum trading risk at $10,000, and as the trade hits $10,000 losses, his position will close automatically. However, who wants to lose as much as $10,000? Archie can always use stop losses just like any regular trade in a carry trade. He can set a stop loss at $1,000 to limit the risks. It means that once Archie gets a $1,000 loss, the stop order will close his position automatically. HE can do all this while holding onto any interest payments he collected when his position is still active.
So, what do you think about carry trades?
In theory, carry trades are plain and simple. However, a wise trader will always keep an eye on economic factors that can impact the currencies we trade.