In currency markets, carry trading is done by many investors to take benefit of the basic economic principle that money flows where the returns are high. This constant flowing in and out of capital between the different markets is what makes carry trading profitable.

Carry trading is quite popular among professional forex traders. Hedge funds and investment banks also do leveraged carry trading to make profits. You as a retail forex trader can also benefit from carry trading.

Carry trading means taking benefit of the interest rate difference between two currencies. Carry traders take benefit of the interest rate differential between two currencies by buying or going long on the high interest rate currency and selling or going short on low interest rate currency.

Lets make it clear with a simple example: suppose New Zealand dollar is offering an interest rate of 4.75% while the Japanese yen is offering an interest rate of 0.25%.

An investor who wants to capitalize on this interest rate differential will buy New Zealand dollars (NZD) and sells Japanese Yens (JPY). The investor can earn a profit of 4.75-0.25=4.5% as long as the NZD/JPY exchange rate does not change. If the investor uses a leverage of 10:1, this 4.5% return will be magnified into 45%.

If the currency pair NZD/JPY appreciates, the investor can get a capital gain as well as a yield on the investment. When there is a carry trade opportunity, many investors jump on the bandwagon. The more investors carry trade, the more the currency pair appreciates.

Carry trades will generally be profitable when investors have low risk aversion and unprofitable when investors have high risk aversion. In times of high risk aversion, investors tend to take refuge in safe haven currencies.

However, if the low interest currency appreciates to some extent for different reasons, carry trade will become unprofitable. In such a scenario, the more the low interest currency appreciates, the more unprofitable carry trading that currency pair will become.

How do you check the mood of the investors? By knowing whether the currency is overbought or oversold. For this you need to identify the current trend of the currency pair and see whether it is moving in the right direction!

You can use the MACD (moving average convergence divergence) indicator to identify the trend.