Upon opening a forex demo account, one of the first questions that you must answer will be about the kind of strategy you will be employing during trading. There are many different approaches to this basic problem, with some being more useful and promising than the rest, but one method that has remained popular and profitable over many decades is the carry trade.

We need to recall a couple of factors about the carry trade before we go on to discuss its advantages and disadvantages. A currency pair generates interest income from the rate differential between two nation’s central banks. Since each position taken in an account is due for overnight settlement, and extending the duration of any trade beyond that time frame involves the payment and receipt of interest, the difference between the yields of the currencies bought and sold determine the overall gain or loss (that is, the carry) of any open position.

In the carry trade a trader aims to hit two birds with one stone. Upon opening a position in one of the typical carry pairs, such as the AUDJPY, or EURJPY, your account will immediately be accumulating interest income as a result of the rate differential between the two currencies, as mentioned above. At the same time, the natural appreciation of the carry currency against the financing currency will be another sizable, and often positive addition to your balance. In addition, a carry trader has an extra layer of protection against the risk that the trade will go against his expectation, since the accumulated interest gains extend the buffer area that each position has before it must be liquidated (i.e. the stop-loss order is realized).

Carry trade is justified on the notion that a central bank paying a high interest rate to foreign investors is able to justify that income through the dynamism of the nation’s economy. Thus, by buying the high-yielding currency, we are not only entering a technically solid and profitable trade, but also adopting a fundamentally sound posture by taking the side of a healthy and growing economy.

But as with most things in forex, this pleasant, and confidence-inspiring picture is not all that characterizes the carry trade. A simple but often ignored fact about high yield is that it is always associated with high-risk, since a fundamentally solid nation’s assets would offer enough long term value to traders to allow low rates by the central bank. Yet high-yielding currencies are often dependent on the inflow of speculative money to such a high degree that it is very hard to speak of “low risk” while evaluating their fundamental conditions. Currencies favorable to carry traders often run large trade and current account deficits, suffer from significant public and private sector imbalances, and immature financial systems (although the situation differs from nation to nation). As a result, a carry trader must always keep leverage low, and keep a close watch on the total risk of his portfolio in order to avoid sudden, dangerous, and painful disappointments.