A swap is an interest fee charged to a trader to keep the position open overnight.
When using certain trading strategies, the traders do not encounter swaps, while other strategies allow making money on them.
Read this article to learn what the trader needs to know about the swap, its types, how it is linked to the 2008 crisis and how the trader can make some good money on them.
1. Fact 1. There are different kinds of swaps
2. Fact 2. The 2008 subprime mortgage crisis was the swap’s fault
3. Fact 3. Swaps emerge due to the nature of mutual settlements between big market players
4. Fact 4. A currency swap is a derivative of the difference in interest rates on the currencies included in a pair
5. Fact 5. Swaps can be either positive or negative
6. Fact 6. Currency swaps can be either long and short
7. Fact 7. Triple swap is charged from Wednesday to Thursday
8. Fact 8. Swap charges can be avoided
9. Fact 9. You can make money from swaps
10. Fact 10. There are swap-free trading accounts
As far as the currencies go, the currency swaps apply where a commission is charged or debited from an account when you are trading various instruments. We are going to examine this swap type in more detail below.
The stock and securities markets have their own swaps. In the commodity market, there is a commodity swap on metals, raw materials, and energy products.
There is a special type of swaps called the credit default swaps which are a credit derivative which allows “swapping” or offsetting the credit risk with that of another investor. The parties transfer credit risks on debt securities (bonds) both state, corporate and mortgage ones to each other.
Specifically, the credit default swaps were involved in the U.S. mortgage market bubble which ultimately led to a crisis.
There are also interest rate swaps. Essentially, these swaps are the type of a derivative contract concluded between market players to exchange interest on certain amounts.
Traders in financial markets are typically interested in swaps on currency pairs, as well as stocks, raw materials and CFDs. Let’s consider how the swap occurs using the example of the foreign exchange market.
Forex market operates around the clock from Monday to Friday. This schedule is explained by the fact that one trading session is followed by another. But in actuality the trading session ends at 9:00 p.m. GMT each day.
This is when the brokerage companies need to close all positions and make relevant settlements with banks. According to this rule, the positions left open from the previous day are basically closed and reopened by a brokerage company, with the swap being charged.
Why does a brokerage company charge the swap on an open position when carrying position open overnight? The answer is simple: that’s because a new day may not be the same in terms of trading environment as the previous one. It is important to understand that swaps on currency pairs are formed based on the interest rates defined by the central banks in those countries, the currencies of which are included in the trading instrument.
The currency swap is a product of the trade amount, the difference between the interest rates and commission charged by the brokerage company divided by one hundred.
This figure is multiplied by the current price of the pair and divided by the number of days in a year
However, the trader does not have to remember this formula or use it to make calculations. The swap is calculated automatically by the brokerage company and mentioned in the trading terms. You can also see the swap rates in the MetaTrader terminal in the relevant section.
We already know that swap is a derivative concept resulting from the difference in interest rates. However, each country has its own refinancing rate level, and by subtracting one rate from another, we obtain both a positive and a negative figure. For that reason, swaps on different currency pairs can be either positive and negative.
Let’s consider the following example. The ECB interest rate at the time of writing is 0.0%. The FRS interest rate is 1.75%. Therefore, the swap for the EUR/USD pair will be negative.
In contrast, in terms of the NZD/CHF pair, where the rate of the Reserve Bank of New Zealand is 1.0%, and the rate of the Swiss National Bank is at -0.75%, the swap will be positive.
In the foreign exchange market, the swap figure differs when opening long or short positions. So, a long swap is the amount credited when opening long positions, and short swap is charged when opening short positions, respectively. Basically, swap is either credited to the client’s account (in case of long positions) or debited from it (in case of short positions). To find out what the swap amount is, check out the terms and conditions on the website of a brokerage company.
The foreign exchange market operates five days a week. That being said, weekend days are also factored in when charging the swap. The swap for Saturday and Sunday is added to the swap amount for carrying the position open from Wednesday to Thursday. This explains why the triple swap is charged on this day of the week.
When using intraday trading strategies, including scalping where positions are opened and closed within one trading day, the swaps are not charged. It does make sense, since the position is not held open overnight.
If you are willing to do whatever it takes to avoid unnecessary trading-related expenses and not pay swaps, opt for intraday strategies. On top of that, you’ll sleep better at night, knowing that you have no open trades.
Given the fact that there are positive swaps, and negative long swaps for a number of pairs can become positive when this instrument is sold, traders have developed a strategy for trading positive swaps which is called the carry trade.
Essentially, you open the trades where the swap will be positive. Aside from that, the positions need to be opened in such a way as to allow you to make profit as a result of the price movement. If you incur a loss in a trade, you may also lose the amount of accrued positive swap.
There are so-called swapless accounts, also known as Islamic accounts offered by some brokerage companies. They are a great option for those who prefer medium and long-term trading where positions are kept open for several days.
That being said, the brokerage company still pays the swap when making settlements with the banks. This is why the commission to open a position is typically higher in swapless accounts.