Beginner’s Guide To Forex Swaps
The forex market offers enormous opportunities to everyone who steps in with a good understanding of the market dynamics and trading concepts. This basic level of knowledge is essential for exploring the volatile currency markets with ease. You must be well-versed with the commonly used forex terms like currency pair, pips, as price, bid price, lot size, spreads, leverage, margin and more. But forex swaps are one important forex term that many beginners need to remember to learn. Enough knowledge about applying swap rates can lead to costly mistakes in forex trading.
So, today we will educate you about swap rates with this comprehensive guide that will give you an overview of currency swaps and their relevance in forex trading.
What are Swaps?
As you may already know, the trading instruments in forex trading are international currencies traded in pairs. Here, one currency will be valued and quoted against another, allowing traders to profit from favourable fluctuations in exchange rates. Various economic factors impact the exchange rates of currencies, and the interest rates charged by the Central Bank of each country are one such aspect influencing the value of currencies.
The Central Bank interest rates are an important element that frames the monetary policy of each economy as this is the rate at which the Central Bank gives loans to other banks in the country. This actually determines the interest paid and earned by the general public in bank transactions. Transactions that involve holding a currency will always result in an incidence of interest, just like how we receive interest on a bank deposit and will pay interest after taking a loan from the bank.
The interest rate applied on forex trades or transactions is referred to as forex swaps. Here the swap charges are calculated based on the interest rate differences of the currencies traded in a pair. For instance, the swap rate for USD/JPY will be determined based on the interest rate difference between US Dollar and Japanese Yen. Like interest charges, swaps can also be paid or received by the trader based on the currencies they trade with. However, there is a special account offered by the brokers, which is known as an Islamic account where no swap charges are levied upon the traders. So, traders can keep the position open overnight without worrying about swap fees.
How Are Swaps Calculated?
The formula for swap calculation is given below:
Swap = lot size *(interest rate of base currency - interest rate of quoted currency/100 )+ markup ( brokerage fee) / 365 or 366 (number of days in a calendar year)
The swap rates in forex are applied only in the case of overnight trade positions, which means it is incurred when you keep a trade running overnight. There won't be any swap charges for trades that get closed before the end of the day. Swap rates are also referred to as rollover fees, as the broker charges at the end of the day at a specific time. A rollover happens when a trade gets extended to the next trading day without settlement on the same day.
The calculation of swap rates may be complex for a beginner to perform manually. Hence, you can use the online swap calculators offered by forex broker websites and online trading platforms for free. You just need to enter the required data into the swap calculator, which will automatically perform the swap calculations to give you instant and accurate results. The duration of trade plays a role in calculating swap rates.
FX Swaps and Cross Currency Swaps
There are primarily 3 different types of swaps in forex: FX swaps and cross-currency swaps. FX or forex swaps is the regular swap rate calculated based on interest rate differences in 2 currencies traded as a pair. This will be either credited or debited to the trader’s account.
Cross currency swaps happen when two companies who trade on a foreign exchange market agree to engage in a spot trade which is settled later on with another trade in future, similar to a forward trade. In accordance with this contract, they each sell the other the same amount in various currencies at the rate in effect immediately following the swap operation itself, not at a higher interest rate based on market fluctuations. They sell the amounts back to one another at the rate specified in the forward contract after a predetermined duration of time that they have agreed upon.
Example for Fx Swap and How It Works
The swap applied to forex trades can be positive or negative based on the chosen currency pair and the type of trade position opened. If you trade with a pair in which the interest rate of the base currency is higher than the interest rate of quoted currency and decide to go long by buying the base currency, then this will result in a positive swap. The positive swap will be added to your account balance, like how you earn interest on a bank deposit.
But if the interest rate of your pair’s base currency happens to be lower than the quoted currency’s interest rate and you go long on the pair by opening a buy position, then there will be a negative swap as the swap charges will be deducted from your trading account balance.
In the case of long trade positions, the swap will be stated as a long swap; for trades where traders took a short position, there will be a short swap. Most swap calculators will display the results as both long and short swaps so that traders can plan their trades based on the type of trade position they plan to open. If you have any confusion regarding the working of the swaps, then you can practise in a demo account to find out how swap affects your trades without risking your capital.
For example, we will try to calculate the swap rates for the USD/JPY pair, taking USD as account base currency, the duration of trade is 5 days, and the lot size is 1. Here we get a long swap of 0.17 and a short swap of -0.39. The negative symbol actually tells that the swap is negative and will be charged against your account balance.
Can I Earn Money From Swaps in Forex Trading?
The simplest way to earn money from swap is entering trades where the swap will be positive. In every pair, there will be positive and negative swaps based on whether you go long or short. So, you can open trades where you stand a chance to receive a swap from your broker. There is also a swap-based forex trading strategy known as carry trading, where you buy and hold a currency with a higher interest rate against a currency with a lower interest rate for a longer duration. This way, you will keep earning positive swaps from your broker and can earn without actually trading.
Conclusion
With this, we are concluding our guide to forex swaps and hope you learned something new and useful from the write-up. Understanding the concept of forex swaps is necessary for traders relying on long-term forex strategies like swing or positional trading. Because swap chargers can add up to your trading cost and need to be calculated in advance before opening a long-term trade position in the forex market.
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