A Forex carry trade is a type of trade which has been generalized into being a specific and powerful trading strategy or style.
In order to explain carry trading well, first we need to understand its place within Forex trading strategies.
What’s the difference between a day and a week?
No. Really, what’s the difference?
That one is bigger (longer)?
But they’re essentially the same thing: time.
You just have more time in a week than you do in a day, right?
It’s the same with many of these trading strategies.
Scalping is usually the shortest-term one, with a trader executing multiple trades in a day.
Then we have Forex day trading, in which a trader executes trades throughout a trading session (one, maybe two trades, on average).
When you hold a trade for a few days, or even weeks, we call this a Forex swing trade.
And finally, when you hold a trade for months or years, we have a Forex carry trade.
It’s worth pointing out, some people count position trading as being between swing trades and carry trades in duration.
Others say a position trade IS a carry trade.
In the swing trading page I defined position trading as being the same as swing trading.
So who’s right?
No one is right, and no one is really wrong.
If we were librarians trying to classify these strategies, and we were looking for exact definitions, then we would care about this discussion.
But you’re here to make money trading Forex, aren’t you?
Therefore, what you really care about is how these strategies change when you hold a trade longer.
A trade is a trade.
But holding a trade for a minute is very different from holding it for a year.
Therefore, the nature of the trade itself (how long you can hold it) will make you care about different aspects of the trade.
This occurs because of the specific characteristics of the opportunity, not because of how a trading style is called.
Say a Central Bank announces its going to tighten conditions until its currency gets on par with the dollar.
Currently, the exchange rate is far from the target, and it will take months if not years to get where the Bank wants to be.
This is a clear opportunity for a carry trade.
You will have to place a super-wide stop because during that year, many things will happen.
The trade will go against you Big time. Maybe thousands of pips against you.
But in the very long-term, you will end up winning.
Therefore, you will hold onto the trade and make a killing when you finally unwind the position.
However, to be able to do this, you would need deep pockets.
Some traders decide to de-leverage, as in, place a trade size lower than their account balance. This way, you won’t be stopped out of the position as easily.
On another note, a Forex carry trade is usually associated with gaining a difference between interest rates in the holding currencies.
When you hold a currency pair, you will pay or receive the difference between the interest rate of the currency you bought and the one you sold.
You receive interest from the currency bought.
You owe interest from the currency you sold.
The net of these two flows determines whether you win or lose interest.
This is a very important thing to consider when performing a Forex carry trade.
If you hold a pair for months, you can earn or lose a sizeable amount of money based on interest rate differentials.
This is why many carry trades focus on buying high-yielding currencies such as the antipodeans (NZD and AUD) versus lower-yielding currencies such as the JPY.
The antipodeans are popular choices (New Zealand).
This shows why JPY is such a popular choice for the counter-currency of a Forex carry trade, since its interest rate is among the lowest (in negative territory).
Contrast these considerations with those of a day trade.
You see some safe haven flows from USD to JPY due to geopolitical issues involving the United States, and boom!
You get in and out of a short USD/JPY in a single session, netting yourself some pips.
Since you don’t plan to hold the pair till the next session, you couldn’t care less about interest rate differentials.
See what I mean?
What about swing trades?
You will hold the pair for a few days? You probably don’t care about rate differentials.
You won’t care even if you hold a pair a few weeks.
There isn’t a point where you should clearly start to care.
It’s unlikely you’ll have to ask yourself whether you should care.
In most situations, it’s pretty clear what you’re going to do, otherwise, rethink your trade.
And that’s it folks, Forex carry trade explained.
See you soon,
The Forex Economist
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