WHAT ARE SWAP LONG AND SWAP SHORT IN FOREX?

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Swap is generally commonplace in the forex and CFDs industry. Accompanying this financial term are two important subsets: swap long and short.  But many traders still lack a comprehensive understanding of these words and even mistakenly use them. That is why this article will give an elaborate description of this terminology and its importance in the financial market.

Swap: Definition and Significance

Definition

When it comes to swaps in the forex industry, various people usually think of a situation where foreign exchange agreements are employed by two different parties to exchange a predetermined amount of money in distinct currencies. Normally, transactions will be reversed at the maturity date. Applying this set of rules, entities can trade currency and interest rate swaps on an over-the-counter (OTC) system.

For example, Company A loans Company B a certain volume of the US dollar (USD) and in turn receives an equivalent quantity of the euro (EUR). When the contract expires, the borrowed dollars will be returned to Company A and the euro amount will be given back to Company B. The contract can last up to one year or more as per the purposes of participants and occupy a significant market share of the financial industry. So little wonder that the term swap regularly reminds people of such agreements.

Nevertheless, this article wants to mention another sub-aspect of this terminology in the foreign exchange market: an FX swap rate which refers to the interest rate differential between the bought currency and the sold one.

In most FX swaps, the instruments will be delivered two days after the transaction date, which is known as T+2. For example, two parties sign the contract on Monday, so Wednesday will be the due date. In case you would like to extend its maturity, the agreement will be left open until Thursday. However, in the retail forex market where traders participate in CFDs trading and are not concerned about whether they receive or deliver physical assets, traders don’t need to abide by the T+2 recipe. Moving forward, they widely use the rollover tactic to keep open positions overnight.

Understanding a Swap Rate in Forex and CFDs Trading

A swap rate is inextricably associated with the term rollover which is a process of rendering open positions rolled over to the next trading day rather than closing them at a spot value date. So, a swap rate is better known as a rollover rate or overnight funding. This period allows traders to extend their loan due date.

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As you know, currencies are always transacted in pairs, which means traders will open a long position for one currency and simultaneously short the other. Therefore, if the interest rate of the bought asset is greater than that of the sold one, a swap rate is positive and you will earn the differential. Otherwise, the rate is paid off to the broker provided the interest rate on your short position is higher. Beyond that, interest rates that might increase or decrease based on the monetary policies of central banks can change the swap’s value.

Significance

A swap rate or a rollover is an important factor in the forex and CFDs market, especially for those who are about to hold a position over the long haul with hopes of profiting from the interest rate.

This strategy is universally seen in carrying trading transactions. In particular, carry traders use the borrowed amount of a low-yielding rate currency to buy an instrument (e.g. currencies or bonds) offering higher interest rates. Assuming you borrow some Japanese yen with the short-term lending rate of minus 0.1% to purchase Australian dollars (AUD) or invest in AUD-based derivative products that give a yield of 0.1%. The interest rate difference of 0.2% is an earned swap rate.

Even when to carry trading is not your type, you can leave some positions open until the next trading day, except for weekends and holidays, if you consider the spot date as an improper time to get out of the market and think that rolling over positions comes with more benefits afterward. Swing or position traders may accordingly take this factor into consideration when building a trading plan. Meanwhile, many day traders are not concerned about a rollover period because their foreign exchange trades will be closed or settled within a business day.

How to Roll Over Open Positions

It is unnecessary to contact brokers in advance if traders prefer to open an overnight position. Instead, in case they set no stop on trades before 5 p.m Eastern Standard Time (ETS), equivalent to 10 p.m Greenwich Mean Time (GMT+0), their positions will be automatically held. This time is technically regarded as a standard signal to end a business day in the forex market.

Despite advancements in technologies that allow foreign exchange transactions to be conducted 24 hours today in different trading sessions, all brokers require customers to settle their transactions before that time unless they want to be charged swap fees. This formula may be applied in the cryptocurrency market, yet other financial offers and derivatives can have different overnight trading hours.

What is Swap Long and Short in Forex?

A swap rate in the forex market is classified into two categories: Swap Long and Short. When you expect the currency pair’s price to be bullish, you will open a long position – that is, make a purchase and generate profits from that estimated increase. By contrast, in the short transaction, you sell the instrument with the expectation of its value depreciating.

If you are going long on the EUR/USD which means selling the US dollar and concurrently buying the euro, for example, the swap rate of one night will be a result of deducting the interest rate of the US dollar from that of the euro. In comparison, the swap rate of shorting the pair is calculated by the division of the euro interest rate from the dollar one.

However, the broker generally uses the more complicated calculation to gauge the swap rate of different pairs:

Where:

  • Rswap         = The swap rate or the rollover rate
  • Rbase currency   = The interest rate of the base currency
  • Rquote currency = The interest rate of the quote currency
  • E = The exchange rate of the currency pair

Accordingly, the swap long and short rates of chosen currency pairs can be estimated. In place of manual computation, you may use some free calculators provided by the broker on its website. Nevertheless, some people find it unnecessary and time-consuming because all trading platforms now – whether proprietary or third-party – automatically calculate the possible swap rates. You can check these figures on the customized software by:

  • Going to the Market Watch section
  • Right-clicking on your selected instruments
  • Choosing the Specification tab and then observing the essential parameters of the asset

(Source: mql5.com)

In the above picture, the swap long rate of the AUD/USD pair is 1.16, whereas its swap short is minus 1.46. Those figures are measured in pips which are the standard unit of evaluating the pair’s price movements. How much the one-pip change costs depends on your position size and trading currency.

To illustrate, you fund the trading account in the US dollar and then decide to buy a standard lot of the AUD/USD, equivalent to 100,000 units of the Australian dollar. The swap long amounts to US$11.6 per day (= 100,000 x 0.0001 x 1.16), versus the swap short of minus US$14.6 (= 100,000 x 0.0001 x – 1.46).

The outcome concludes that if you hold this long position until the next trading trade, the earned interest rate will be added to the account balance. Meanwhile, shorting the position comes with a negative interest rate. However, interest rates are floating and profoundly affected by various factors such as economic indicators. Nothing ensures that a longer holding time of the bullish trade will always accompany the positive rate and vice versa. So, watching major news regularly is needed to see how interest rates fluctuate.

Weekend Swaps

Another consideration when you learn about the swap rate is time to roll your trades over. In case you open a position on Monday and hold it until Thursday, the swap rate will be imposed for three nights. Now, imagine that you enter a trade on Friday, the position will be kept until Monday because banks and large financial institutions, main participants in the forex market, cease to work on weekends. However, this does not mean weekend swap rates will be excluded. This can be explained that to help keep your positions over weekend breaks, the broker has to spend financial and human resources maintaining the system for open trades.

Similarly, keep in mind that when you don’t settle a trade before 5 p.m EST on Wednesday, the position won’t be closed out until Monday. This translates to great interest rate earnings or huge losses as you are confronted with the five-night swap. Hence, if you don’t guarantee a positive carry trade, you are advised against executing overnight positions over this time.

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