Being the most prevalent type of trade in the forex market, the carry trade is based upon the principle that every currency has an interest rate.
Put simply, the trader invests in the currency with the high-interest rate and finances it with the currency with the low-interest rate. Depending on the marketplace and timing of investment, the yearly return from the difference in interest rates between the respective currencies could be extremely high and yield very little appreciation.
While you might be inclined to run out and buy the next high-yielding pair, it’s important to be cautious as the carry trade can have severe and rapid declines. Known as the carry trade liquidation, this occurs when it’s decided upon that the carry trade won’t have any future potential. Once this is called, every trader and investor starts to seek his/her exit strategy. Then bids will start to disappear, and ultimately profits from the difference in interest rates aren’t nearly enough to cover all the capital losses. Essentially for the carry trade strategy to successfully work, anticipation is key.