Carry Trade strategy is one of the most popular fundamental Forex trading techniques. It's used not only by the individual traders but also by the big hedge funds.
The main principle is that the trader sells currency with a low interest rate and at the same time buys a different currency with a higher interest rate. The trader exploits the difference between the rates and make profits, based on the leverage used.
This techniques provide profits not only from the currency pair's fluctuations but also from the interest rate difference (overnight interest rate). However, this system This applies to normal global economic conditions. It is not recommended for volatile market conditions. Besides your forex broker should be one of those that actually pay overnight interest rate difference if you want to earn from it. You won't be able to earn from it if your broker is "swap-free".
First you have to figure out the interest rate differential and the forecast for the selected currency pair. Then you basically go long a currency with a high interest rate and short a currency with a low interest rate. Hold the position for a while based on your trading plan to take advantage of the interest rate differential.
For example, the British Pound has a 4.50% interest rate and the Japanese Yen has a 0.50% interest rate. Then difference (the interest rate differential) is 4%. Consequently if you borrow Japanese Yen at 0.50% interest rate and invest it in the British Pound you should be able to earn 4% in interest.
The main danger with the carry trading strategy is the same as with other longer-term forex systems. The currency you are holding can depreciate against your home currency. If your forex indicators show that it is going to happen, it is time for you to get out. Many forex traders set their stops on the long term carry trades at their trades entry point. This locks in carry profits and stops the trade before suffers losses. Again, that carry trading is a long term system and should be treated as such, so don’t stress out on intraday profits and losses.
Remember that the higher is your leverage the bigger is the loss if something goes wrong. High leverage used in carry trade can result in losses if the market moves sharply in the undesirable direction. Your trade is then prone to hit the margin calls or to be automatically closed when the stop/loss is reached.
Finally, the Interest Rate can Shift. In case the interest rate differential broadens – good for you! This is exactly what you are looking for. On the other hand, if the interest rate differential shrinks down, you will end up with almost no return.
On the short term trading level the carry trader focuses on the interest rates which definitely play in the FX market a crucial role. A country offering high interest rates will attract more capital as investors seek to capitalize higher returns. As interest the rates rise, the investment follows, which can in turn increase the value of the currency. Carry trader's main focus is the expectation on the direction of a country's interest rate.
Nowadays the term carry trade applies to any correlation between the FX and a fundamental factor such as the interest rates, unemployment or even oil price, copper price etc.