What is carry trade when trading forex in Dubai? | Get Financial Freedom Tips | Transform Your Financial Future

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Thursday, February 10, 2022

What is carry trade when trading forex in Dubai?

When we spoke with several traders in Dubai about carrying trade, many of them had no concept of what it was.


forex trading


Some think that carry trade refers to carrying goods from one country to another, but this is not the case. 


What is carry trade?


Carry trade refers to borrowing money at low-interest rates and investing it in high yield investments. 


When you are trading currency pairs, you are trading two currencies simultaneously. You exchange your base currency for an alternative currency or "the counter currency". 


When you go long on a currency pair which means you bought a higher-yielding asset (currency) with a lower one (base currency), then it's called positive carry trade because the difference between the yield of both assets you bought is your profit.


In the same way, when trading forex, if you went short on a currency pair, you sold a higher-yielding asset (currency) with a lower one (base currency). 


It's called negative carry trade because the difference between the yield of both assets you bought is your loss. 


Trading in any financial market, this rule applies where traders are always looking for high return investments and lower risk to earn higher returns on their money than what it would have earned if it was just sitting idle.


Most forex traders invest in carrying trade when they are long on higher-yielding currency with a lower one ( base currency ). 


In simple words, higher-yielding investments with less risk. Fund managers might not know it, but their funds carry goods to other countries just like what was mentioned before, even though banks and other financial institutions do it instead of themselves.


Fund managers always want to get higher returns than their peers. So they will park their money into higher returning currencies to increase their returns compared to others while investing in low returning currencies for safety reasons to avoid losing capital during downturns. 


At the same time, they invest in high returning currencies to increase their returns. When you are trading forex, if you have a significant long position or buy a lot of base currency, it's called positive carry trade, which means the difference between the yield of both assets is your profit.


If you have a significant short position or sell a lot of base currency, it's called negative carry trade, which means the difference between the yield of both assets is your loss. 


Low yielding currencies are generally prone to risk because investors look for safer investments when bad things happen in financial markets. Higher yielding currencies are generally less affected by market changes than low yielding ones.


Typically, most near term events affect higher-yielding currencies more than lower ones, but general economic conditions can also affect them. 


So it's a complicated matter to decide which one is riskier because it depends on the time frame you are trading and general economic conditions that can change at any given time.


Now when you go along with a carry trade, your profit is determined by the interest rate difference between higher returning assets and lower-yielding ones, as well as changes in those rates over time. 


But if borrowing costs rise more than what your profit from the investment does, then you would have made losses, so looking at records alone won't help you predict future profits/losses as things can be different now compared to before.


Many traders lose money consistently with this strategy for years, even though they follow the rules without understanding how things work under the hood. 


Main components of the carry trade


In general, banks and financial institutions have a lot of capital because they have been trading for years, so they would invest in assets worldwide where returns are higher than what it cost them for borrowing those assets. 


As long as their return from investing is more than their borrowing costs, they will continue to increase their net asset values.


In conclusion, the carry trade stays a risky strategy that can result in high profits or huge losses, primarily if using leverage.


Link to forex for more information.

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