If you want to be able to benefit from carry trade, you simply have to buy a higher-yielding currency versus a lower-yielding one.
In effect, you are holding on to a currency with a higher interest rate and selling the one that has the lower rate. With that, you can be able to profit from the interest rate differential alone even if price action remains steady for a few days.
Let’s take a look at an example. When you buy the Australian dollar and sell the euro, in effect shorting EUR/AUD, you can be able to earn a positive interest rate differential of 2%.
This assumes that the RBA still gives an interest rate of 2.50% while the ECB offers a 0.50% interest rate. With a good account size and enough leverage, you can earn from compounded interest if you hold on to the trade for more than a day.
When you keep a trade open for a day, what really happens is that your broker closes the position at the end of the day then reopens it the very next day.
It happens automatically so you won’t see this on your platform. In turn though, the interest for the next day is rolled over and gets added or subtracted from your account.
Advantage and Disadvantage of Carry Trade
Carry trade can work against you too if you are short a position on a higher-yielding currency versus a lower-yielding one.
For example, if you are selling New Zealand dollars in exchange for U.S. dollars and you held on for a day, you get a -1.50% return since the RBNZ gives a rate of 2.00% while the Fed has 0.50%.
Remember also that risk sentiment must be on your side when taking advantage of carry trades. This means that market sentiment should be favoring a rally of higher-yielding currencies versus lower-yielding ones, as traders would rather take on more risk.
This way, you can have positive returns from your forex trade and add to your wins with the positive rate differential. On the other hand, when risk is off and higher-yielding currencies are selling off, you can still earn from positive carry but lose on your forex trade.
The bottom line is that you have to remember two things when trying to benefit from carry trade. Firstly, you have to buy a higher-yielding currency or one that has a higher interest rate and sell a lower-yielding currency or one that has a lower interest rate.
Secondly, you need to make sure that risk appetite is up so that you can also earn from a winning forex trade on top of a positive interest rate differential.