Positive and Negative Swaps
A trader must understand a trading account before anything else, and to this end, trading with a demo account before switching to a live one is strongly recommended. Trading can be misleading, as the trading costs differ from broker to broker, and from one trading account to another. There are hidden costs that must be considered, and when entering the Forex market, the retail trader does not consider these costs that are associated with trading. However, depending on the trading style, these costs can affect the profitability and, to some extent, the trading strategy. Let me give you an example: If the trader is a scalper (meaning he/she will take multiple trades for a short time), then the costs to look for are commissions and spreads. If someone is swing trading, the swaps-related costs come on top of the above-mentioned ones. Moreover, if the trader is an investor, the problem becomes even more serious, as the time taken for a trade to reach the target, or for a trader to close a trade, plays an important role in the overall profitability of a trading account.
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Currencies are strongly influenced by their interest rate. A higher interest rate is bullish for the currency, as everyone wants to own it. A lower interest rate signals a weak currency, and traders will sell it. In trading, however, it is the future expectation of the interest rate that moves prices. This is when central banks enter the picture, as interest rates are set by the central banks. A currency pair has two currencies; therefore it represents two different interest rates that are set by the respective central banks. The difference between the two interest rates is called the interest rates differential, and it can be positive or negative. In a retail trading account, this is called a swap. However, it should not be misinterpreted, as the difference is not the arithmetical one.
For example, if the interest rate in the Eurozone is -0.4% and in the United States it is 1%, the interest rate differential is NOT the difference between the two. It is close to that, but not identical, as other factors are priced in as well. The swap in a trading account reflects this interest rate differential. This can be positive or negative, and is applied daily on a trading account. As a result, scalpers are not affected by swap differentials, as most of their positions are open and closed on the same day. Swaps are deducted from/added to the balance of a trading account at the end of the trading day. It is said that the positions are rolled over. This is because, effectively, these represent contracts that are rolled over to the next trading day. At the end of the day, based on this interest rates differential, the swap of a currency pair can be positive or negative, which means that a small amount is either deducted or added to the balance of the trading account. As a rule of thumb, most of the currency pairs have a negative swap. Only a few have a positive swap, and owning such a currency pair overnight leads to, of course, speculation. If your trading size is big enough, even if the currency pair is not moving, an income is added to the trading account at the end of each trading day. The bigger the volume of the opened positions, the bigger the amount credited to the account.
Positive swaps are paid these days if one is short on EUR/USD, long on AUD/USD, long on USD/JPY, and so on. But, as mentioned earlier, most the pairs have a negative swap for both long and short positions. The swap differs from currency pair to currency pair, and among Forex brokers as well. Moreover, the swap changes over time, as conditions will change because central banks change monetary policy. These positive swaps are the reason for “carry trades”. Large funds and institutional investors tend to buy currency pairs in a risk-on situation to benefit from these positive swaps. It led to an overcrowded market, with large swings that took out the wrongly positioned traders. But this is what swaps do: they influence the way a trading account is handled. A swing trader and an investor must consider the associated costs entailed by a negative swap. If one pays $10 every day for a position to be kept open and rolled over, during a trading month it means a cost of over $300 dollars. This cost must be deducted from the eventual profit, or added to the eventual loss. So, if anyone asks the trader what the profit or the loss was, this cost should be added. It comes on top of the spread costs and the commissions associated with the trading positions. In view of this, swaps are very important, and their effects on the trading account must be known.
Recommended Further Reading
- Fundamental Analysis – CPI and its Importance in Forex Trading
– Explaining inflation, and why it matters for Forex trading. Also, covering the central bank’s reaction to higher or lower inflation levels.
- Fundamental Analysis – NFP – What is it and How to Trade it
– Why the NFP is one of the most important economic releases for the Forex market. Explaining why volatility increases on all currency pairs when the jobs data in the United States is released.
- Fundamental Analysis – Explaining the US Economic Data – Part 1
– Covering all data that matters from the United States – 1st part.
- Fundamental Analysis – Explaining the US Economic Data – Part 2
– Covering all data that matters from the United States – 2nd part.
- Fundamental Analysis – Explaining the US Economic Data – Part 3
– Explaining the US Economic Data – 3rd part.
Other Educational Materials
- Exchange rate exposure, hedging, and the use of foreign currency derivatives. Allayannis, G., & Ofek, E. (2001). Journal of International Money and Finance, 20(2), 273-296.
- “Managing foreign exchange risk with derivatives.” Brown, Gregory W. Journal of Financial Economics 60, no. 2 (2001): 401-448.