What is a swap in forex?

Highlights

A swap in foreign exchange (forex) trading, also known as forex swap or forex rollover rate, refers to the interest either earned or paid for a trading position that is kept open overnight.

Suppose a forex trader wanted to increase their trading position but was unable to afford large deposits; they could use margin accounts and leveraged funds. This would allow them to borrow funds from a broker, while depositing a smaller amount themselves.

Essentially the trader would be taking out a loan, which they would be required to pay or receive an interest rate on. This interest rate is called swap.

What does swap mean in forex?  

Within the forex market, every currency has its own interest rate, determined by the country’s central bank. Whether a trader receives or has to pay a swap depends on the interest rates of each currency in the forex pair. 

The swap rate, also known as the rollover interest rate, rollover swap or swap rate, is the interest payment that is made or received for holding a position overnight. It is charged when trading on leverage, as when traders open a leveraged position they are borrowing funds to open the position.

The difference between the swaps is called carry. Some traders will deploy carry trading as a strategy, which involves borrowing in a currency with a low interest rate and investing in a currency with a higher interest rate. The aim is to earn interest on their position via the forex swap.

Forex traders use currency pairs, the base currency comes first, and the quote currency comes second. For example, in the British pound to US dollar (GBP/USD), the pound would be the base currency and the dollar the quote currency. 

Each time a trader opens a position they are making two trades: buying one currency in the pair and selling the other.

If the currency bought has a higher interest rate than the one sold, a swap will be credited to the account. If the interest rate is lower for the bought currency, a swap will be charged from the account.

Swaps don’t occur when a trade happens within one day. So if a trader opens a position and closes it that same day, there will be no interest rates charged. If they decide to leave the position open for more than a day, a swap will be activated.

Rollovers

In forex, a rollover is the action that takes place at the end of the day, where all open positions with a value date, (the date when the value of an asset that fluctuates in price is determined) equals spot, are rolled over to the next business day.

For example, let’s say today is Monday – spot GBP/USD will have a value date of Wednesday. As Monday comes to a close (17.00 ET Time) – spot GBP/USD will roll forward a day to Thursday. Now the price for GBP/USD is different for those two value dates. 

The rollover  is also commonly known as the ‘tomorrow-next day’ or ‘tom-next’ rate. 

The intention of the rollover or tom-next rate is to prevent traders having to take physical delivery of currency, while still being able to keep their forex positions open overnight.

Like commodities, forex trades tend to result in a trader taking delivery of the asset they have traded. In forex, the expected delivery day is two days after any transaction, known as the spot date, but rollover/tom-next rate can be used to extend the trade beyond this date.

So, instead of accepting delivery of the currency, the rollover rate allows for the position to be extended, and the provider swaps any overnight positions for an equivalent contract that starts the next day.

When calculated, the difference between these two contracts is the tom-next adjustment rate.

Let’s say that you decide to trade the GBP/USD pair – you open a position to buy £100,000 and sell USD at a price of 1.1366. 

In order to keep your position open beyond the expected delivery date, you would need to sell your £100,000 the following day and then buy it back at the new spot price.

Rollovers happen once a day at 21:00 GMT. 

Calculation of rollover interest

The calculation of rollover interest rate depends on several factors, the first is:

• Currency pair being traded

• The interest rates of the two currencies 

• Direction and size of position

Let’s take as an example the EUR/USD currency pair. The base currency is the euro and the quote currency is the dollar. This means when buying EUR/USD, a trader would be buying the euro and selling the US dollar. 

If the euro has an interest rate of 3% compared to 1% for the dollar, the trader would be credited the interest rate difference of 2%. However, if USD has a higher interest rate, they would be debited the interest rate difference.

The amount of swap depends on the financial instrument you are trading – it can be a positive or negative rate depending on the position you take. 

If it is negative, the trader will be charged for holding the position overnight. If it is positive the trader will be credited for holding the position overnight.

Long-term traders dealing with a high volume of orders could choose to try and avoid the forex swap, by either trading directly without leverage or using a swap-free forex trading account.

If you do decide to use leverage, you should be aware that as well as making gains, you can also make losses and trading with leverage does come with its risks, which could lead to you losing money.

There are several factors affecting rollover interest rates: 

• Central banks: central banks globally set interest rates, which impact the rollover interest rates. 

• Brokers: Some brokers only apply the interest rates of central banks, whereas others reserve the right to modify them according to market conditions. Many brokers may decide to modify rollovers in their favour, so doing your research on brokers and finding the right one for you is very important. 

Understanding overnight positions

An overnight position in forex trading is a trade that remains open until the following business day. 

You should consider the following factors when holding an overnight position: 

• The currency interest rates in the two countries.

• The price movements of the currency pair.

• A shift in investor sentiment could affect the traders position before the next trading period opens. 

• Forex traders should also be conscious of weekends and regional holidays that could also broaden the risk.

Foreign exchange swap vs cross currency swap

A foreign currency (fx) swap is an agreement between two parties to exchange a given amount of one currency for an equal amount of another currency, based on the current spot rate. A currency swap requires both parties to pay periodic interest payments in the currency they are borrowing. 

The difference between foreign exchange swaps and cross currency swaps is that in the former, both parties own the amount they are swapping, whereas with cross currency swaps parties are lending the amount from their domestic bank and then swapping the loans. 

Forex swaps trading strategies

There are various strategies for trading forex swaps. These include a swap long,  when a long position is kept open overnight or a swap short, when a short position is left open overnight.

• Long position strategy: Long-term traders, who hold a position open for a longer period of time have to pay close attention to the swap rate, as it adds up every day on your balance.

• Short position strategy: The swap rate for short term traders may have less impact than for those taking a long position, as the trades are held for a shorter period of time.

• Carry trading: This allows you to earn interest on your position via the forex swap. This type of strategy does come with its risks and traders can lose profit if the market moves against them.

• Hedging with forex swaps: Currency swaps can be used to hedge against the risk of exposure to exchange rate fluctuations. 

• Risk management with forex swaps: A foreign currency swap can be a useful tool for forex traders, as the swapped amounts can be used as collateral for repayment.  

The swap fee is determined by a number of factors, such as the online broker you use, so doing your research on different brokers ahead of trading will help you uncover the best broker for your needs.  

The swap fee varies depending on: 

• The type of position – purchase or sale 

• The instrument 

• The number of days the position is open

• The nominal value of the position

Most brokers charge a swap rate between 23:00 to 00:00. Sometimes a swap is charged for holding a position over the weekend, even if the position is not held over the entire weekend. This is done to compensate for the markets closing during this period.

A weekend swap rate will either be charged on a Friday or a Wednesday. This means, if a trader holds their position overnight on the day that weekend swaps are applied, they may pay three times the normal swap charged on your trade. Therefore, it's best for traders to check with their broker to confirm when a swap charge will be applied.

Conclusion

The swap in forex trading refers to the interest that traders either earn or pay for a trade position they keep open overnight. It can positively or negatively affect profits, depending on the swap rate and position you take on the trade. This means, traders will either have to pay a fee or will be paid a fee for holding the position overnight.

In spot forex trading, a rollover is the  procedure of moving open positions from one trading day to another. If a trader extends his position beyond one day, he/she will be dealing with a cost or gain, depending on prevailing interest rates, and this is known as the rollover interest rate.  

Traders could consider using various strategies, such as  the carry trading strategy to earn interest on their position via the forex swap, but it does come with its risks and could wipe out any potential profit if the market moves against you.

Remember, that markets can go up and down, and never trade more money than you can afford to lose. Traders should be aware that as well as making gains, they can also make losses and trading with leverage does come with its risks, which could lead to traders losing money.

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