What is swap? Pros and cons
SWAP TOM NEXT. Swaps at Forex – what is it?
If you thought that swap is a fee for rollover of the transaction for the next day, it is not true. It seems that swap is similar to spread, which is payment for brokerage service. However, the formation of a swap, its size and essence has nothing to do with the purchase of the service. So, what are swaps at Forex and how are they formed?
A trader trading in the currency market is dealing with a swap only if he/she needs to transfer an open order for the next day. It means that in case of intraday trading within the short timeframes, a trader will not be dealing with swap. What is swap?
In the foreign exchange market a swap is an operation in which the interest rate of the base currency is deducted from the interest rate of the quoted currency; as a result we will have a swap on the long position with a rollover for the next day.
In case you have forgotten, let me remind you that in the currency market short position - is a sell order, while long position is an order to buy. So, if you have placed an order to buy some amount of base currency for the quoted currency, you have opened a long position.
In the case of the rollover of such position, a swap will be accrued to your account, which will be equal to the difference between the interest rates of the Central Banks of the countries, which currency you are buying and the currency you are selling. If you have a short position (you have opened a position to sell), the swap is calculated in the opposite way: the interest rate of the quoted currency will be deducted from the interest rate of the base currency, and the difference is accrued to the trading account of a trader.
I use the word "accrued". However, a swap can be both negative and positive. If the swap is negative, the funds will be withdrawn from your accounts); if the difference in interest rates give a positive swap, the funds will be deposited to your account. Now, you see why a swap cannot be considered as a fee for service?
Now let’s look at three examples to demonstrate all possible options of swaps accrual
- Example No. 1: Say, your favorite financial instrument is GBP/USD. You have placed an order to buy GBP/USD for the amount of 0.01 lot, which means that you buy 1000 British pounds for USD. The interest rate in the USA is now 0.5%, while the rate in the UK is also 0.5%. If you leave your position for "overnight", next morning you will not see any changes on your account, because 0,5 – 0,5 = 0.
- Example No. 2: Suppose you have opened a long position on the currency pair USD/CHF. Interest rate of the Swiss National Bank is -0.75 % (Yes, it is negative). When a transaction is rolled over, from 0.5% of the US interest rate we will deduct -0.75% of Swiss interest rate: 0,5 – (-0.75 per) = 1.25 percent. This amount you will receive on your trading account next morning, if you transfer the order for the overnight.
- Example No. 3: Now, let’s take the currency pair USD/AUD. When we buy USD for the Australian dollars, transferring the position for the overnight, next morning we will have: 0.5 – 1.75 = -1.25. It means that this amount will be withdrawn from your account.
Pros and cons of swaps
Based on the above we can say that a swap in the Forex market can be positive, negative, or zero, (if the interest rates of the Central Banks of both currencies are equal). Using a swap you can both: make or lose money. The main thing is to make a good choice of the financial instruments for trading on larger timeframes.
Characteristics of swap trading
As we mentioned above, traders, who prefer intraday trading should not worry about swaps. However traders who prefer trading on longer timeframes should learn more about swaps. These market participants should know that there are ways of trading with swaps.
- You can obtain information on the selected swap for the specific currency on the specific day in the trading terminal.
- You can also follow the changes in the interest rates made by the Central Banks on the broker’s website.
Banks do not work at weekends, while a swap is calculated not on the day, to which an order is transferred, but on the next day, it means that a swap is accrued on the third day after the rollover.
If you open a position on Wednesday, and transfer your order for Thursday, calculations will be made on Friday, and accrual will be postponed until Monday because Saturday and Sunday are the days off. What impact will this have? On your trading account the amount of swap will increase for several times for the weekend.
Well, now you know more about swaps.
I wish you profitable trading, whatever timeframe you prefer!