What is a carry trade and how does it work? This is a fair question to ask if you are uncertain about how you might get involved with such a trade or what you may need to do to make it happen. Let’s dive into it.
The best way to view a carry trade is to think of it as working best when investors feel like taking a risk on high-yield currencies and sell low-yield ones.
Economic conditions don’t have to be particularly strong, but the appetite for purchasing currencies does. If that is set up just right, then you can potentially make a nice profit by playing with carry trades. You can make a profit off of the interest rate differential between the high-yield currency that you purchase and the low-yield currency that you are selling.
When Do Carry Trades Fail?
There are moments when a carry trade may not work for you as you hoped or anticipated. If a country’s economic prospects are bad, then no one is going to want to take on the currency of that country, and it can be a challenge to get anyone to make the purchase. If the market thinks that the central bank is likely to lower interest rates, then things can be particularly challenging for the carry trade to work.
If you get the sense that risk aversion is high in the market at this time, then you will likely want to avoid placing any carry trades at all. It is simply too big of a risk and a test for you to deal with. Make sure you instead focus on the ways that you can perhaps make money on other forms of trading in the meantime. Think of it as an opportunity to break out of your box and experiment with other forms of trading that you might not have had the opportunity to try out otherwise.
Weigh your options between cashing in on that interest rate differential and taking on too much risk in the form of a carried interest trade that is simply too risky.