Risk and Criteria for Carry Trade

Let's go over the carry trade criterion.

Finding an appropriate pair for a carry trade is quite simple. Keep an eye out for two things:

• Look for a large interest rate difference.

• Look for a currency pair that has been stable or has been trending in the direction of the higher-yielding currency. This allows you to profit from the interest rate differential by staying in the transaction for AS LONG AS POSSIBLE.

Let's look at a real-world example of the carry trade:



This is a AUD/JPY weekly chart. The Bank of Japan had maintained a “Zero Interest Rate Policy” during this time, with the interest rate hovering around 0.10 percent.

Also abbreviated as ZIRP.

Many traders flocked to this pair as the Reserve Bank of Australia boasted one of the highest interest rates among the major currencies (4.50 percent in the chart example) (one of the factors creating a nice little uptrend in the pair).

From the beginning of 2009 to the beginning of 2010, the price of this pair fluctuated between 55.50 and 88.00.

That's a total of 3,250 pips!

When you add in interest payments from the interest rate differential between the two currencies, this pair has proven to be a good long-term investment for many investors and traders who can weather the currency market's unpredictable ups and downs.

Economic and political considerations, of course, change on a daily basis.

Interest rates and interest rate differentials across currencies may fluctuate, making popular carry trades (like the yen carry trade) less appealing to investors.

Taking up Trade Risk

You already know the first question you should ask before starting a transaction because you're a savvy trader, right？

“How much of a risk am I taking？”

Correct! Before you enter a transaction, you must ALWAYS consider your maximum risk and if it is acceptable in light of your risk management guidelines.

Joe the Newbie Forex Trader's maximum risk in the scenario at the start of the class would have been $9,000. Once his losses reached $9,000, his trade would be automatically closed off.

Doesn't seem very appealing, does it？

Remember, this is the worst-case situation, and Joe is still learning the ropes, so he hasn't really grasped the importance of stop losses.

You can still limit your losses in a carry trade the same way you can in a typical directional transaction.

For example, if Joe elected to restrict his risk to $1,000, he might place a stop order to liquidate his trade at whatever the price level for that $1,000 loss would be.

While retaining the position, he would keep any interest payments he received.