At its core, trading forex is about swapping different currencies simultaneously, unlike standalone instruments like equities. Many large financial institutions partake in foreign exchange swaps solely to secure cheaper debt, speculating, and hedging fluctuation risks.
At a retail level, we are constantly dealing with pairs. Our decisions to buy or sell can solely depend on how strong or weak a currency is compared with another. The practice of trading any pair comes with leverage, which functions similarly to a loan, except traders incur or get paid interest.
Understanding how traders earn or incur swaps in different markets is crucial for swing traders, position traders, or just long-term traders in general, who often hold their orders for several nights consecutively.
What are swaps, and why do they exist in forex?
The swap in forex is interest applied to a trader’s positions for ‘rolling them’ overnight (hence also referred to as the rollover). The rollover in currency trading begins at 5 pm or 6 pm EST (Eastern Standard Time), depending on daylight savings.
This time is effectively the start of the new trading day or the beginning of the Sydney session. The vast majority of brokers apply the swap somewhere within the first hour of this period.
Positive rollover (which credits a trader’s account) occurs when buying a currency with a higher interest rate than the one being sold in a pair. Conversely, negative swaps happen when one sells a currency with a lower interest rate than the one being purchased in a pair.
It is common for the rollover to be slightly negative regardless of whether the trade is a buy or sell if the interest rates between the pairs are similar. Any swap will apply for every day or night a trader holds their positions.
Rollover fees do change every so often as central banks increase and decrease interest rates accordingly.
So, why do swaps exist in the first place? It all boils down to leverage and having the privilege of trading larger positions. Margin functions very much like a loan as traders are effectively borrowing each time they trade.
For instance, placing a buy order on USD/JPY means one is buying US dollars and selling Japanese yen simultaneously. We would need to borrow funds from the broker to be able to make this trade.
Understanding the triple swap charge
Technically, swaps apply for all days of the week. However, we have ‘triple swaps,’ where the swaps are tripled typically on Wednesdays.
Such practice accounts for the weekend when the markets are closed, which has to do with the T+2 settlement period. Although it’s common knowledge currencies are traded ‘on the spot,’ their actual settlement is not immediate but rather after two days once the transaction or position has been closed.
A trade done on Tuesday settles on Thursday; a position executed on Wednesday settles on Friday, but one done on Thursday would technically settle the following Monday. As markets are closed on the weekend, a triple swap applies at 5 pm EST, which is practically the start of a fresh 24-hour Thursday trading day.
The calculation method for swaps
Swap rates come from financial organizations working with brokerages. Fortunately, some brokers have integrated calculators on their websites for swaps, where traders only need to input a few simple details like the pair in question, position size, and whether the trade is a buy or sell.
In other cases, brokers do not provide any form of calculator to know the swaps. Regardless, it does help to understand the calculation behind the rollover.
Although there is no 100% standard formula across the board, most brokers calculate the swap using something like this:
Pip value for one lot X lot size X swap rate in points X number of nights divided by 10.
Swaps rates are affected primarily by the interest rate differentials and the broker’s commission.
The carry trade strategy
The carry trade is a unique strategy used chiefly by long-term or position traders who hold their positions for several weeks, months, or years to earn positive swaps. Here, the investor will first look at the pair with the highest positive interest rate differential.
After establishing this, the trader would buy the currency with the bigger interest rate within a pair. For instance, let’s assume the interest rates for Japan (JPY) and South Africa (ZAR) are 2% and 5%, respectively.
This would give us a positive differential of 3% if we were buying the ZAR/JPY market. The investor would earn swaps for every day they held this position, provided they maintained the margin requirement.
Knowing the best markets with the best differentials is the easy part. The trickiest part is the exchange fluctuation risk in holding the orders for indefinite periods. So, the other aspect of the carry trade is considering the directional bias and ensuring it is optimal for a buy or a sell order.
The carry trade requires a huge stop to stomach extended fluctuations against the trader in virtually all cases. We should remember swap payments aren’t large amounts but can accumulate to sizable figures over time.
Therefore, those using a carry trade approach will need to thoroughly consider the exchange rate risk and factor whether the swaps accumulation will cover their downside over time.
Compared to spreads that affect all traders, only traders holding their positions overnight should concern themselves with swaps. Rollover fees are pretty reasonable for more popular and traded markets, namely major and minor pairs.
However, certain exotic pairs like USD/TRY, GBP/TRY, USD/ZAR, etc., have higher swaps because the interest rates of so-called developing countries are inherently higher than their first-world counterparts.
Carry traders favor such markets if they happen to be on the right side of buying or selling. Of course, any long-term trader on the wrong side may find themselves accumulating a lot of rollover over weeks or months.
Hopefully, the reader will have gained a better understanding in this article of why and how rollover interest applies in the realm of online forex trading.