When using the phrase forex swap in the conventional way it is used to describe a derivate trading product that is an agreement to exchange currency between two parties in order to reduce foreign exchange risk. More on this can be read here.
However, from the retail forex trading standpoint, it refers to the interest earned by holding a position overnight. In this article lets look deeper into what exactly is a forex swap, how to calculate it and how can you earn money from it.
What is a Forex Swap?
When opening a margin Forex position at your broker, you are effectively borrowing capital and, as a result, interest on it is accumulated if the position is kept overnight. This is called a rollover. Time of rollover can vary from broker to broker, however, usually its around midnight GMT.
In forex trading, you essentially both sell one and by other currency at the same time. Therefore, the difference between interest rates, for example, for buying EUR, and shorting the USD is the amount of swap rate you can earn. An additional swap fee or dealer spread is usually charged for holding the position. Together with the previously mentioned difference between interest rates the final amount you can expect to either earn or pay is called the net swap rate.
As mentioned before, the rate of swap depends on the interest rate differential between currency that is bough and the currency that is being sold. Additionally, increased volatility in the market can cause movements in the swap rate as the broker adjusts for the increased risk.
The swap buy and sell rates are provided for your broker either on their website or trading platform. Make sure to check them in order to understand what are specifics for each currency. They can vary from broker to broker and can result in a net negative swap rate even if the currency with a large interest rate is sold against a currency with a low interest rate.
Triple swap on Wednesday
Due to the forex market being closed on the weekend, brokers need to make up for the interest either earned or paid during this time. This is done by the so called triple swap.
The reason why it is usually done on Wednesday is simple – it takes 2 days for forex contracts to settle. However, some broker do a triple swap on Friday, therefore, make sure to check the specifications of your trading account.
By simply opening a position with a positive swap rate before the triple swap date and exiting it just after the rollover, a trader can get a quick profit. However, any profit can be quickly lost if the market moves against you.
How to calculate swap?
All you need to calculate the swap rate is the contract size, current price, interest rate difference as well as markup that make up the swap rate.
Therefore, the formula is easy:
Swap = (One Point / Exchange Rate) * Trade Size (Lot Size) * Swap Value in Points
For example, we short 3 lots (300,000 USD) of EUR/USD with a swap rate of 0.75 for 1 night and an exchange rate of 1.1.
This results in the following swap earned:
Swap = (0.00001 / 1.1) * (300,000 * 0.75) = 2.04545 USD
This means that for each time you hold a position overnight during the rollover time you will earn 2.04545 USD. However, different brokers can calculate this differently and usually offer their own swap calculator.
The most popular way to profit from a high swap rate is the so-called carry trade. This means buying a currency with high interest rate while selling a currency with a low interest rate. This means that the broker will effectively pay you to hold this position overnight.
An example of this would be to sell EUR against a currency from emerging markets that offer a high interest rate. As long as the market does not reverse against you, you will slowly accumulate swap earned.
If the market remains calm and ranges for several weeks, as this is a long-term strategy, this can amount up to a very large profit since leverage is used. This can, however, be risky as the market exchange risk is still in play. Therefore, if the position moves against you, it will likely eliminate all the profit from the overnight swaps accumulated during a carry trade.
Events such as Central Bank intervention can quickly change the direction of the price and eliminate all profits. Important is to follow the interest rate developments as, during periods of increasing interest rates, traders increasingly purchase the currency and cause an additional increase in price that further adds to the profits of a carry trade. Websites such as tradingeconomics.com track the history of interest rate changes for various Central Banks, for example, history and forecast of Euro area interest rate can be seen here.
Additionally other market and global events can impact these developments and it is important to stay up to date. Read more on market news here.
Impact for swing traders
Due to swap being paid overnight traders who hold positions for several days or even weeks have to pay attention to the swap rate. Holding a long position in a currency pair that has a negative swap can result in a substantial reduction in potential profit. This is especially true when markets are trending slowly.
However, the opposite is true when opening a position with a positive swap rate. You can boost your profits significantly with the addition of swap that is accumulated over several days or weeks. This can result in a profitable trade even if it is exited at a break-even price.
Therefore, before opening a position always check the swap rates. This is especially true for less popular currencies that frequently have a very high interest rate. Due to this, a seemingly good trade can turn into a loss very quickly.
Read more on how carry can impact your trades here
- In forex, swap is something to always keep an eye out for. As mentioned before, shorting a currency with a high interest rate can quickly reduce any profits. The opposite is true for a long position, however, high interest rates usually are a sign of declining exchange rate currencies. It is often hard to have a long-term position in order to accumulate swap against the overall trend even if the swap rate is high.
- Therefore, it is not as easy as simply purchasing a basket of high interest currencies and earning interest on them in a carry trade. However, this can be an additional factor to consider when expecting a reversal in a declining currency before entering a counter-trend trade.
- Additionally, always keep an eye on what are the swap calculation methods and rates offered by your specific brokers. They can and will vary and can amount to substantial additional trading costs.
- Decisions of central banks impact interest rates, therefore, keep an eye out for what are the latest forecasts and rates across the world. Changes in them will respectively either increase or reduce the swap rate that the broker offers for both buying or selling a currency pair.