What is swap, what are its types and how to make money with it

Concept of swap in Forex trading

10-04-2020

Swap in Forex is an interest fee that’s charged or earned for keeping positions open overnight. Swap is also referred to as an overnight interest or a rollover rate.

What is swap in the Forex market you can understand from the name itself: it is charged to open trades aimed at buying/selling the foreign currency which is essentially an exchange of currencies.

Swap applies only to those traders who engage in middle-term and long-term trading.

Swap and what is it

Сontent:

1. What is swap and what types are there?
2. Islamic accounts or how to trade without swaps?
3. Swap is an excellent way to make money for traders: Carry trade

What is swap and what types are there?

The size of this commission is based on the difference in rollover rates in countries, the national currencies of which are included in a currency pair.

Depending on the difference in rates, the swap can be either positive or negative. It should be mentioned that the monetary policies of central banks change as the years go by, which means that both the rates and the difference between them change as well.

The swap calculation is as follows:

When buying the currency pair, the swap is calculated by subtracting the interest rate of the base currency (which is the first in the pair) from the interest rate of the quote currency (which is the second in the pair).

Therefore, if the rate of the first central bank is higher, the swap will be positive. Conversely, if the interest rate of the central bank of the quote currency is higher, the swap will be negative.

To demonstrate how this works in practical terms, here’s an example.

Let’s say we are buying EUR/USD currency pair. If the interest rate is 2% for €, and 1% for $, we will get a positive swap of about 1% by holding positions open overnight.

2 % – 1 % = 1 %

If we sell EUR/USD pair, it means that we buy the U.S. Dollar and sell the Euro. In case of the rollover, we will get a negative swap of about 1%.

1 % – 2 % = –1 %

If we sell USD, which we actually don’t have initially, it’s like we are borrowing it and essentially paying an interest rate of 1%. When we are selling what we don’t have, we pay the interest rate for using the borrowed money. E.g. when buying Euro, we agree that our position can also be used to issue a loan for the sale of Euros to other traders.

So, when we purchase something, we get the interest rate, and if we sell something, we pay the interest rate for being given a loan since we were allowed to sell what we did not have. Basically, this very difference in interest rates is called the swap.

The swap is shown in the trading terminal when you open a position and hold it open overnight. The swap is displayed where other indicators, such as profit/loss and the opening/closing price are displayed.

Swap and its display in the terminal

Triple swap is charged or earned at night from Wednesday to Thursday, since the banks don’t work on the weekends but we still have to pay or receive the interest rate. So, you should keep this in mind.

More often than not, inexperienced traders believe that if they pay swap for holding their positions open overnight, this implies major losses. This couldn’t be further from the truth if you trade major currency pairs. That being said, when it comes to exotic pairs, you should always factor in the swap.

Given the fact that the interest rates of the central banks in major countries are insignificant, both positive and negative swaps are unlikely to hit you hard in the wallet. E.g. if we consider the EUR/USD swap, its size will be minimal if this position is held for about two weeks.

However, when your positions remain open for 3+ months and even a year, you should pay closer attention to swaps. In this case, it would be more feasible to opt for swap-free accounts.


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Islamic accounts or how to trade without swaps?

If you seriously wish to avoid the hassle associated with swap charges, you should consider swap-free or Islamic trading accounts. The name is explained by the fact that the Quran observed by Islam followers prohibits financial transactions, in which the interest is earned. This is why the Forex swaps are not appropriate for them, yet they still wish to trade in the foreign exchange market.

With this in mind, forex broker Gerchik & Co have come up with special swap-free accounts that allow Islamic traders to engage in currency trading. However, now traders are using these accounts as well regardless of their religious beliefs.

Not all brokerage companies offer swap-free accounts. Besides, the company loses nothing here anyway: the trader will still pay for the rollover just in a different form. So, make sure to carefully read the terms and conditions of such accounts, since other commissions for them may be higher than traditional ones.

Swap is an excellent way to make money for traders: Carry trade

As previously mentioned, the swap is a fee that is debited from the account or credited to it, and experienced traders have mastered the art of making money with it. This trading strategy is known as the Carry Trade and can generate profit if the price stands still for a long time.

Carry trade strategy is successfully used with those currency pairs which are characterized by greatest deviation of interest rates e.g. GBP/JPY, AUD/JPY or NZD/JPY. Essentially, the idea behind carry trading is to buy a currency with a high interest rate while simultaneously selling another currency with a low interest rate. In this case, the profit is generated both through quote fluctuation and the difference in interest rates. The profit in this type of trade is long-term, and so you can keep the positions open for not only one to two weeks or several months, but also for years.

NOTE:

This strategy can be applied in a calm economic environment, but it is definitely not a good idea to use it during global economic crises.

Trading the carry trade strategy is done as follows:

  1.  open the chart window of the desired currency pair which is characterized by a high positive swap (such pairs have been mentioned earlier in this article);
  2.  predict the direction of price movement on daily, weekly, or even monthly charts;
  3.  make a buy or sell trade, while factoring in the positive swap direction and the desired trend; do not place the stop loss order;
  4.  wait;
  5. close the trade if you see that the profit has increased thanks to the swaps and you are okay with the amount.

When trading the carry trade strategy, you don’t have to keep an eye on intraday price fluctuations, since you expect to make a profit in the future. Don’t panic if initially the trade goes slightly into the red. When using this strategy, the profit is formed due to the positive swap.



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