In forex, all we’re doing really is ‘swapping’ one currency for another through the use of margin. Technically, leverage involves some form of borrowing, to which brokers apply a swap or interest for holding these positions.
Understanding the swap is imperative primarily for traders who hold their trades overnight. Those who close their orders before the rollover period won’t feel the effects. Nonetheless, it’s beneficial for any investor to understand more about the swap, how it works, how it’s calculated, and ways in which they either incur or receive such fees.
What is a swap?
A swap or rollover is a form of interest applied to open positions held overnight that traders can either incur or be credited with depending on the differentials between the two currencies traded.
Overnight in forex means from 23:00 or 00:00 server time or 5 pm-6 pm EST (depending on daylight savings time). Most forex pairs have their rollover period for an hour at this session, though some exotics with limited opening times will have theirs at a different time.
What we should remember about leverage is traders are effectively borrowing larger funds using a smaller deposit. Even so, this is not a traditional loan incurring interest payable after a specific term. Swaps come into play here, except they incur overnight each day a trader maintains their positions.
Let’s consider how we are essentially borrowing currencies whenever we are trading. What makes forex unique is we trade in pairs, meaning we effectively always make two trades simultaneously. In other words, one is buying a currency and selling another or vice versa.
If the interest rate of the currency one is buying is lower than the one they are shorting, they will incur negative interest for every day they keep that order. Conversely, if the interest rate of the currency they are buying is higher than the one they are selling, they will receive positive interest for each day that position is held.
When are swaps applied?
As briefly mentioned, brokers automatically apply swaps on a trader’s account during the rollover period, which is an hour between 5 pm EST and 6 pm EST (or 6 pm-7 and pm EST for daylight savings).
Typically, brokers apply swaps on Mondays, Tuesdays, Wednesdays, and Thursdays. A ‘triple swap’ might apply on the following Wednesday/Thursday/Friday if a trader held an overnight position on Thursday before the rollover period.
The reason for the triple charge has to do with the settlement dates for forex contracts, which is two days. Although we don’t see this effect, trades technically only settle two days later on the broker’s side. Even so, since the markets are closed on weekends, the triple charge counts Friday, Saturday, and Sunday.
How are swaps calculated?
Sadly, there is no universal method all brokers use to calculate swaps. However, they would use a calculation similar to the one below or some variation thereof:
Pip value for one lot X number of lots X swap rate X number of nights / 10
- Pip value for one lot. Of course, this will vary depending on the instrument, but most pairs’ pip value for one lot is $10. The broker does provide all the different values in micro, mini, and standard lots for more straightforward calculation.
- Swap rate. The swap rate varies widely across brokers, and it’s a beneficial idea to shop around. Similarly to the overall swap calculation, there is no ubiquitous way they decide the rate.
What we know is it at least consists of the interest rate differentials between the two currencies in a pair and whatever mark-up they apply.
Can traders use a strategy to earn swaps?
The most popular strategy for earning swaps is known as carry trade. It involves capitalizing on the highest positive interest rate differential possible and holding positions indefinitely to accumulate credited swaps.
With this system, one is not concerned about a directional bias; whether the market goes up or down, the hope is the swaps will more than cover the downside. The biggest disadvantage with the carry trade is it requires a large stop loss.
More importantly, most swap costs aren’t particularly great, meaning the trader might need to maintain a position for several months just to break even. If the market went against them too much, this might erode any of their swap gains.
Nonetheless, one consideration for potentially profitable carry trade is trading exotics since the rates are a lot higher than traditional major and minor pairs.
Regions like Europe, Japan, America, Switzerland, etc., have adopted zero-interest-rate policies. Therefore, the differentials between these countries are very little or sometimes even negative.
However, countries with less traded currencies like Russia, Mexico, South Africa, and Turkey show positive differentials when paired against their more popular counterparts.
Can some traders avoid swaps in forex?
As briefly mentioned, traders like scalpers and day traders who naturally close their orders well before the rollover period easily avoid paying swaps. Needless to say, other strategies rely on time and will need one to hold their positions overnight.
Unfortunately, if a trader just so happens to be trading a pair that would make them incur a negative swap, there is no mitigating solution. A possible option is an Islamic account, a special type of account exclusively for Muslim traders.
This type of account adheres to the principles of Sharia law, which prohibits the accrual of interest. However, there is no guarantee every broker will offer this account to a non-Muslim client. Therefore, it is entirely up to their discretion.
Of course, some strategies require traders to keep their positions for several consecutive nights either because it’s part of their plan or they are in a losing trade. Unfortunately, some may not be aware of how swaps could have an impact on their bottom line.
Along with spreads and commissions, swaps are another cost worth thinking about when choosing a broker, especially if one holds their trades overnight.