A swap is a commission charged by a broker for moving an open position to the next day. The size of the swap is determined individually for each currency pair and is indicated in the specification on the broker’s website. Practical application of a swap means a commission, while a deep understanding of its essence allows us to develop a strategy for earnings. And let the strategy be applied only a few times a year, we hope you will be interested to learn how to implement it.
What is a swap and how to make a profit on it
A swap is the simultaneous execution of transactions on one asset with the same volume in opposite directions, but with different value dates. The first transaction closes the position opened by the trader, the second opens it immediately, but the dates of the transactions are different. Transactions are made without actual delivery of the currency, but the purchased currency is reserved or “put on deposit”. Accordingly, the currency sold is taken from the Central Bank on credit and a percentage is charged on it in the amount of the Central Bank’s discount rate. Since the period of holding the position in the market is unknown, then there is a dependence of the swap on the deposit and credit rates of the countries with whose currencies the transaction takes place.
- If the deposit rate of the Central Bank is more than a credit, then the swap is positive, that is, it is credited to the trader’s account.
- If the loan rate is higher than the deposit rate of the Central Bank, the swap is debited from the account.
For example, if in the US the discount rate (the rate at which the Fed lends to commercial banks) is 0.5% and the interest rate of the ECB is 1%, then the trader can make money on a swap by opening a long position on the EUR / USD pair.
This strategy is called Carry Trade. It is not used as the main one due to too low profitability, but it is quite suitable for novice traders as additional income. The disadvantage of the strategy is that you can lose more on the volatility of currency pairs than make money on a swap. For the greatest efficiency, you need to choose the instrument with the largest swap, determine the amount of the deposit that can withstand the potential drawdown and track the decisions of the Central Bank regarding the discount rates. The greater the difference between the deposit and credit rates of different countries, the more you can earn on the difference.
Often with earnings on swaps, hedging is applied: a trader opens a regular account and an account without a swap (Islamic). On both accounts, a position is opened in different directions for a currency pair with a high positive swap. Brokers are trying to prevent such strategies, exposing all sorts of restrictions. Therefore, it is not always possible to make money on a swap.