There are many strategies that can be applied when trading on the forex market. One of them is the so called carry trade strategy. It is usually applied by investment banks and large macro hedge funds.
How it works?
An investor applying this strategy tends to benefit of the differing interest rates of major economies. S/he looks for trends in the target currency pair and takes advantage of its direction.
The currency pairs to which this strategy is most commonly applied are:
Under carry trade strategy the currency of the pair that has the highest yield is purchased, whereas the currency with the lowest yield is sold. A basket of the mentioned above currency is usually purchased by institutions as a measure against currency exposure and portfolio volatility. The strategy can be used in a combination with different technical analysis tools.
However, this strategy doesn’t provide a 100% guarantee for success, since there are many examples of losses of money even by professional traders.
Forex Carry Trade Strategy Success Requirements
In order to successfully apply the carry trade strategy you should allocate at least 6 months since this strategy works over the long-term. Failure to do so will result in lack of the frequent temporary imbalances of the value of the currency pair.
Additionally, you should properly apply leverage to increase your chances for success. If you leverage too much, short-term fluctuations of the value of the currency pair will not be easily avoided.
The success of the carry trade strategy may be questioned when equity investors put more value on lower interest rates, which is inconsistent with the principles of the strategy. Additionally, in order to successfully apply the strategy, the general environment should be risky. However, the forex market is generally driven by risk aversion.
If the environment is characterized as being risk seeking, then investors will strive at buying assets that carry more risk but are of a lower value.
Since this strategy implies the taking of more risk, then investors are awarded by higher profits as well. If the conditions are of risk aversion, then carry trade strategists may lose since the riskier currencies on which they have bet will decrease in value.
If the risk aversion starts to increase, different signals may be sent by investment banks. They tend to look at the following in order to determine the eventual risk aversion rise:
- Swap spreads
- High yield spreads
- Equity market volatilities
- Forex volatilities
- Emerging market bond spreads
In order to take the best out of the carry trade strategy, you should appropriately diversify and study the level of your and the market’s risk aversion.