In forex, there are several costs charged to traders. If one is not careful, some of these charges may eat into their profits and, on some occasions, turn a profit-making trade into a loss on the account. For that reason, it is important to understand all applicable charges before opening a trade. Swap charges are one among the many charges each trader should have a working understanding of.
What are swaps in forex?
In the Forex market, swap goes by many names. It may be referred to as night premium, rollover, or overnight commission. Essentially, when trading with leverage, the broker loans the majority of the amount required to finance the trade, while the trader only provides a fraction of it as margin. Usually, these loans, so to speak, are lent out to traders for a duration of one day.
However, if the trader leaves their position open for longer than a day, the brokers simply charge interest on the overnight position, which is called a swap. The amount charged as a swap depends on the interest rate differential between the two currencies making up the traded pair.
When is the swap applied?
Swaps are charged on positions that are held overnight. Therefore, the concept of swaps is one that does not affect day traders. Swing traders, on the other hand, since they keep their trades running for days, weeks, or months at a time, have to account for swaps, as they are charged daily.
The forex market is open 24 hours a day, 5 days a week. So, what counts as the end of day in forex? Well, time zones may vary, but basically, the day is considered over at 5:00 PM New York time (EST).
What this means is if you have a position open at 16:59 EST and you close it at 17:01, the overnight swap will be charged to your account. Therefore, you should carefully read your broker’s conditions on the end-of-day cut-off time to avoid being slapped with surprise fees.
When are overnight costs especially important?
In the forex market, when you open and close a position, the effects reflect instantly on your account balance. However, in an actual sense, these transactions are settled two days after the transaction date. This is to say that if you were buying NZDUSD, for instance, you’d get your NZD two days after the date of purchase. There are exceptions to this, such as USDCAD transactions, which are settled after one business day.
Because of this rule, traders who leave their positions open overnight on Wednesday are charged swaps on three nights, as their trade will be processed on Monday of the next week. This phenomenon is known as a triple swap. They are charged swaps on both days of the weekend as the forex market is usually closed.
Calculating swap
The amount of swap charged depends on the size of the position being traded. For instance, if one was trading a standard lot of 100,000 currency units and they left the trade open overnight, the swap charge would be a proportion of this amount (100,000). If a second trader bought a mini lot of 10,000 units instead, applying the same swap rate to their position would yield a lot less swap than that of the first trader.
The swap rate, in turn, depends on the interest rate set by the respective central banks. These rates determine the interbank interest rates, which in turn influence the rates brokers charge to their clients. For this reason, it is not uncommon to see different brokers quoting different rates.
To put it in an equation:
Swap = ((swap rate/365) * position size).
How to capitalize on swaps
There are ways to capitalize on swaps so that you earn money from them. Traders who dabble in this are called carry traders. Their art is simple – first, look for a currency pair whose base carries a higher interest rate than its quote currency. There are several of these, so exercise caution when choosing your currency pair.
The next step is to ensure the currency pair’s price is in an uptrend. At this point, you may enter a long trade spanning a few days. The swaps charged on your overnight positions will be a positive difference in your account.
However, you should be on the lookout for any changes in the interest rates quoted by your broker, as these may change by the day. Further, the trend may reverse at any time, leading you to losses instead.
How to avoid swaps
If you want to avoid paying swaps altogether, the easy way would be to close all your positions before the end of the day. The other option would be to factor in your carry trades and always ensure you’re earning the negative difference. However, that is a risky strategy.
There are special accounts offered by some brokers which do not charge swaps on overnight positions. These are dubbed Islamic accounts, as they adhere to Sharia Law which prohibits the charging of interest. These accounts are meant for their Muslim clients. However, oftentimes these brokers will charge other fees to earn back what they have lost in interest.
Conclusion
Swap refers to the interest charged for leaving a leveraged position open overnight. This rate depends on the interest rate differential between the two currencies of a currency pair. Sometimes, the interest charged may result in a negative interest, which is paid out to the trader. Other, the interest will be charged on the trader’s account. Participants who trade currencies to earn swaps are called carry traders. Some brokers will offer Islamic accounts which do not charge overnight swaps.