Trade Criteria and Risk
Finding a suitable pair to do a carry trade is pretty simplee. Look for two things:
Find a high-interest differential.
Find a pair that has been stable or in an uptrend in favor of the higher-yielding currency. This allows you to stay in the trade AS LONG AS POSSIBLE and profit from the interest rate differential.
This is a weekly chart of AUD/JPY. Until recently, the Bank of Japan has maintained a “Zero Interest Rate Policy” (currently, the interest rate stands at 0.10%).
They are also known as ZIRP.
With the Reserve Bank of Australia touting one of the higher interest rates among the major currencies (4.50% in the chart example), many traders have flocked to this pair (one of the factors creating a nice little uptrend in the pair).
From 2009 to early 2010, this pair moved from a price of 55.50 to 88.00 – that’s 3,250 pips!
Suppose you couple that with interest payments from the interest rate differential of the two currencies. In that case, this pair has been an excellent 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 also change, 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?
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 $9,000. His position would be automatically closed out once his losses hit $9,000.
Remember, this is the worst possible scenario, and Joe is a newbie, so he hasn’t fully appreciated the value of stop losses.
You can limit your losses like a regular directional trade when doing a carry trade.
For instance, if Joe decided that he wanted to limit his risk to $1,000, he could set a stop order to close his position at whatever the price level would be for that $1,000 loss.
He would keep any interest payments he received while holding onto the position.