Carry Trade Criteria and Risk

Carry Trade Criteria

It's pretty simple to find a suitable pair to do a carry trade. Look for two things:

1. Find a high interest differential.
2. Find a pair that has been stable or in an uptrend in favor of the higher-yielding currency. This gives you the ability to stay in the trade AS LONG AS POSSIBLE and profit off the interest rate differential.

Pretty simple, huh? Let's take a real life example of the carry trade in action:

This is a weekly chart of AUD/JPY. Up until recently, the Bank of Japan has maintained a "Zero Interest Rate Policy" (as of September 2010, the interest rate stands at 0.10%).

With the Reserve Bank of Australia touting one of the higher interest rates among the major currencies (currently at 4.50% as of this writing), many traders have flocked to this pair (one of the factors creating a nice little uptrend in the pair).

From the start of 2009 to early 2010, this pair moved from a price of 55.50 to 88.00 - that's 3,250 pips!

If you couple that with interest payments from the interest rate differential of the two currencies, this pair has been a nice long term play for many investors and traders able to weather the volatile up and down movements of the currency market.

Of course, economic and political factors are changing the world daily. Interest rates and interest rate differentials between currencies may change as well, bringing popular carry trades (such as the yen carry trade) out of favor with investors.

Carry Trade Risk

Because you are a very smart trader, you already know what the first question you should ask before entering a trade is right?

"What is my risk?"

Correct! Before entering a trade you must ALWAYS assess your max risk and whether or not it is acceptable according to your risk management rules.

In the example at the start of the lesson with Joe the Newbie Forex Trader, his maximum risk would have been $9000. His position would be automatically closed out once his losses hit $9000.

Eh?

That doesn't sound very good, does it?

Remember, this is the worst possible scenario and Joe is a newbie, so he hasn't fully appreciated the value of stop losses.

When doing a carry trade, you can still limit your losses like a regular directional trade.

For instance, if Joe decided that he wanted to limit his risk to $1000, he could set a stop order to close his position at whatever the price level would be for that $1000 loss. He would still keep any interest payments he received while holding onto the position.

(See more) Summary: Carry Trade   

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