What is a swap in forex? A swap is the interest differential between a pair of currencies. If you go long the EUR/USD essentially you are shorting the dollar and buying the Euro. In this case you must pay any interest due the dollar, but you will receive interest owed to the euro. When you buy or sell a currency pair it is important to know that one side of the transaction will earn you interest and the other will cost you. If the Euro is paying an interest rate of 1.5% and the Dollar is paying an interest rate of 0.50% Then the difference is 1%. Therefore, if you go long the EUR/USD you will earn 1% interest on your trade. If you short the EUR/USD you would own 1% interest on the trade.
Please note forex tends to be traded with significant leverage. Therefore, the interest rate differences tend to add up very quickly. Generally someone who is trading an account balance of $10,000 will actually be trading up to $100,000 of currency at a time. This is significant because the 1% interest payment in our previous example would really be like 10% on the owners account balance. As you can see this interest really can add to your bottom line or eat into profits.
It is important to understand how interest is paid by your broker. The standard approach is that it is paid each day at a certain time. Basically if you make a trade a few minutes before the deadline and sell right after it you will participate in that exchange. Because forex does not trade the weekends, interest counts for three times the payment on Wednesday’s. These are called SWAPS and you will see in your trade log where money is added or subtracted from your trade for the swap. Now before anyone gets excited about jumping in and out of high yielding currencies before the deadline on Wednesday, please understand that you still have to pay the spread and the trade could move against you in the short period of time in between.
So how does this help you in your trading? For most traders the interest difference is not going to make a big difference on trading profits. If a trader tends to trade the same currency both directions, they may overall make a small net gain or loss on interest over a long period of time. Further, some trade may be so short lived that the trader never holds them during the SWAP period. Longer term position traders are most affected by SWAPS. They tend to hold positions for months or even years. In this case it s easy to see how interest can play a big roll. Some currencies have very high yields. For instance the GBP/JPY pays out a handsome SWAP. If the pound has an interest rate of 3% and the yen only 0.25% the net gain by going long the GBP/JPY would be 2.75%. As you can see trading $100,000 worth over the course of a month would yield you $230. If the trader held the position for a full year they would be paid $2,750. That would be a return of 27% on their $10,000 account. This is a great return, but there are obvious risks involved. If the currency moves down in value the trader could lose much more than the interest payment and result in a losing trade. The major benefit to trading in the direction of high interest is that it can help offset small losses so that you can hold the trade longer. This is precisely what they call the Carry Trade.
The Carry Trade occurs when speculators determine that over the long term a high interest paying currency is going to appreciate against a lower interest paying pair. Generally the Euro and the Pound have been high paying currencies and the Yen has been the lowest. Therefore, the GBP/JPY and EUR/JPY have been popular currencies to trade from the long side. The strength of the interest payment is a sign of the strength of the currency itself. Therefore, it is logical to hold long-term the high paying currency.
In summary for many traders the SWAP really does not affect the bottom line and should not be considered when deciding to make a quick daytrade. However, traders who are interested in swing to position trading would benefit best from selecting high yielding currencies.