With interest rates dictating the rate of return for holding assets denominated in the local currency, forex traders also pay special attention to interest rate differences when it comes to keeping their positions open for a long time. This is because the interest rate difference is carried on when a forex position is kept open overnight.
This practice is known as carry trade. When you are buying a currency that has a higher interest rate compared to the counter currency, you can take advantage of positive carry. In other words, you gain a small interest on your forex position if you keep it open until the next trading day and your broker will add that amount to your profits.
Conversely, when you are buying a currency that has a lower interest rate compared to the counter currency, you are losing from negative carry if you keep the trade open for days. You lose a small part of your forex position to the negative interest rate differential, which gets applied to your profits on the next trading day.
For instance, if the Reserve Bank of Australia offers 3.00% interest while the U.S. Fed offers only 0.25%, going long AUD/USD could give you a 2.75% additional return based on your position if you keep your trade open for a year. Shorting AUD/USD gives you a 2.75% loss on your profits if you hold on to your trade for a year. Overnight gains or losses are determined as a part of the annualized interest rate differential.
You’ve probably guessed that much longer-term positions have the potential of benefitting from purely positive carry. Even if you lose from the actual trade or if price doesn’t move at all, you can gain profits each day just by keeping the trade open for a really long time. On the other hand, negative carry can wind up eating a chunk of your profits even if you make small wins on the actual forex trade.
Carry trades can therefore maximize the profits on long-term trades, especially when risk is on. This can be determined by using the market sentiment analysis techniques discussed in the earlier section. When higher-yielders are likely to rally, a trader can benefit from long positions and from the positive rate differential.
Of course carry works negatively when risk is off. Not only do higher-yielders sell off, but also holding on to a short position with these currencies could reduce your profit potential.