Some traders may be unaware that all we’re doing in forex is exchanging one currency for another. For instance, if you were going long (buying) the EUR/USD pair, you are effectively swapping or selling US dollars for euros.
A major reason for the popularity of FX is margin, allowing traders to leverage their positions for massive returns. Some need to learn that leverage comes at a small cost, and this is where the swap in forex trading comes in.
The two direct trading costs we deal with in FX are the spread and swap. So, what is a swap fee in forex, and why is it charged? Let’s explore this concept and more in this article.
What is a swap in forex trading?
So, what does swap in forex mean? The swap in forex means interest fee traders are credited with or debited for ‘rolling over’ a position overnight. This is why it’s also referred to as rollover, accumulating for each day your order is maintained.
The standard daily opening times in FX are from Sunday, 21h00 GMT, to 21h00 GMT on Friday. So, overnight refers to the period after 21h00 GMT, effectively the beginning of a new trading day or the start of the Sydney session.
Your broker will charge or credit you with swap once the clock hits 21h00 GMT (or 23h00 GMT during daylight savings).
So, how do you know if you’ll be credited or charged swap fees forex trading? Positive rollover happens when you purchase a currency with a greater interest rate than the currency sold.
On the other hand, you are charged when you buy a currency with a lower interest figure than the one being sold.
Let’s assume you were looking at EUR/USD, where the euro had a 1% interest rate while the US dollar had a 5% interest rate. The swap in forex here would be favourable if you bought this market (since 1% is less than 5%).
Conversely, the rollover would be negative if you sold this pair, as you are, in turn, buying USD (which has a higher rate).
(First side note: don’t be confused by the subset of currency trading called FX or currency swaps. These markets are based on the same concept of interest rates, but they are usually reserved for institutional traders, not the average person.)
(Second side note: If you are a Muslim trader and can prove your faith, most brokers can offer a swap-free or Islamic trading account. Using it allows you to comply with Sharia law that forbids the earning or paying of interest.)
Why does the swap in forex trading apply?
In exploring the swap forex meaning, why does it apply in the first place? FX is leveraged trading. In the truest sense, we borrow from our broker to open larger positions. Of course, any form of borrowing from a financial institution comes with interest.
Yet, swap forex trading differs from traditional loans because the rollover fee only applies once you hold your position overnight. This is one advantage of scalping and day trading since these individuals generally close their orders before that time.
Another distinction from conventional interest is that you can get paid in interest (positive rollover). This means that, in some cases, it is advantageous to hold trades for the long term, which is good news for swing traders and position traders.
Central banks are responsible for setting interest rates for their respective currencies, typically about eight times a year. Over the past decade, interest rates have remained largely unchanged, especially in so-called developed nations.
Of the eight prominent central banks, the Bank of Japan has maintained a negative interest rate of -0.1% since 29 January 2016. The chart below shows the trend since February 2008.
This means you will earn interest when you sell JPY for other markets, i.e., buying GBP/JPY, AUD/JPY, USD/JPY, etc.
The greater the interest differential, the more the swap in forex trading. Lesser-known or ‘developing’ countries have higher interest rates to attract foreign investment.
These regions include South Africa, Russia, Turkey, and Mexico, among others. The currencies of these nations form part of exotic pairs, which carry traders study (more on this later).
The triple charge swap in forex
When brokers apply the swap in forex trading, you will notice that they are tripled on Wednesdays (or Thursdays with some brokers). This is caused by the T+2 settlement period, which applies to nearly all pairs. When you close a trade, it happens on the spot on your side.
However, on the broker’s ‘back end,’ they technically settle it after two days. The swap on forex positions applies for all the weekdays.
However, a position held overnight on Tuesday is settled on Thursday; a trade held overnight on Wednesday is settled on Friday; a trade held overnight on Thursday is settled on Monday (since the market is closed on weekends).
So, the swap determined on Wednesdays accounts for the previous Thursday and Monday, hence why it is tripled. Here is an image to better describe this process.
How to calculate the swap in forex trading
Fortunately, it isn’t necessary to manually work out the swap fee because brokers have their own swap calculators that update daily. So, you will always know how much rollover to expect beforehand. However, for those interested, here is the general formula:
Pip value * swap rate * number of nights / 10
The swap rate is determined by the broker (which you can find on their website) and includes their commission. The interest rate differential is the main determining factor when observing the swap in forex trading.
So, the higher it is, the greater the rollover you will be credited with or paid depending on whether you went long (bought) or short (sold).
Forex swap trading: the carry trade strategy
Carry trading is a unique technique in exploring the forex swap meaning. It’s a strategy designed to profit from positive rollover by holding a position for as long as possible to accumulate the swap.
This approach has a neutral directional bias because, whether the market goes against or in favour of the analyst, they make money from interest. Observing exotic pairs can help since they have greater differentials than major or cross pairs.
Of course, the swap forex strategy is not risk-free because you typically need a substantial stop loss. This means you must invest more money to make it worthwhile, and you should expect a floating loss for an indefinite period.
If you’re a long-term trader, it helps to pay attention to the rollover, particularly if you plan to hold your position for a while. Some traders go to the extent of shopping around for brokers with the lowest swaps.
It’s not only about indicators, tools and chart patterns. Trading is a risky business with transaction fees, with the swap in forex being one of them. So, pay attention to them at all times for your next position; your equity will thank you for it later.