When it comes to trading, have you ever thought how the financial instruments sellers like currency exchange companies, bond sellers and more earn a profit? When they are trading on the exact same price. Like if buy 1USD from one Exchange Company in London, another Exchange Company which might be in Chicago will be selling on the same rate. So how do they earn money?
This is very hard to explain. Because they are playing on volume and a very, very small amount that for us, which is negligible. That unit is not cents but pips. A pip stands for a point in percentage. A measurement of a price change in a currency pair trading on the forex market. To understand this, let us assume that you have a USD/EUR rate of 0.7747. This means that 1USD can buy 0.7747EUR. So if one pip to like 0.7748, US dollar value has raised against the Euro and this is what a forex company earns. But wait. There is something more.
A forex company calculates something that they call swap rate. This is called a forex swap upon which an exchange company earns money or even loses money. So what is a swap or swap rate? Well, this is very difficult to explain but as this is a basic guide so we will keep is as simple as possible so that you can understand the basic concept of Swap rate or which is also called a rollover rate.
What is a Swap/Rollover rate?
Imagine you purchased a foreign currency on Monday and hold it for a night. Next day you sold the currency. Therefore, by holding it for a night,an interest was either charged by or paid to you. In other words,theswap is the interest paid or earned for keeping the trade open overnight. Swap is the part of the contract of each financial instrument.
Suppose you shorts on EURUSD by 1 standard lot on Thursday and keep the position open overnight, closing it on Friday, you will earn $0.10/- interest.
Or If you go long on EURUSD by 1 standard lot on Thursday, and closed it on the following Tuesday, so the trade was open for three nights, and hence you have paid $14.40/- interest.
Wednesdays are referred to as weekends. So instead of closing on Tuesday, you closed it on Thursday then 7 nights will be counted adding Saturdays and Sundays in the equation hence you have paid $33.60/- interest.
Types of Swaps:
There are two types of swaps. Each swap has its own rate for overnight, and those rates determine if you will pay interest or you will earn interest. The two swap types are as follows:
This is a concept wherein a currency pair, andthe first currency is bought while the other currency is sold.
Suppose that you have pared USD (US Dollars) by CAD (Canadian Dollars) USDCAD in a market where the trend us upwards or which we call a bull market. Now if we follow the definition, you have to buy US dollars against the Canadian Dollars. Suppose that today you bought $10,000 USD at $1.35 CAD this means that you spend $13,500 CAD to purchase $10,000 USD. You hold it still seven nights. Now the exchange rate is $1.40 CAD. You sold your $10,000 USD and hence made $14,000 CAD. This means that you earned $357 in this swap. But while holding the currency for 7 nights an interest was charged and depending upon your profit, it is charged and either deducted or added into your account.
This is a simple example of swap long.
This is a concept wherein a currency pair andthe first currency is sold while the other currency is bought.
Suppose that you have now pared USD (US Dollars) byJPY (Japanese Yen) USDJPY in a market where the trend is downwards or which we call a bear market. Now if we follow the definition, you have to sell US Dollars and buy Japanese yen. Now suppose that you sold $10,000 at 123 rates to buy 1,230,000 Japanese Yen. Now you hold it for seven nights. Now the exchange rate is 119. Hence you closed it by selling your Japanese yen and bought back the dollars. Now you got $10,336 against 1,230,000 Japanese yen. This means you made a profit of $336 in this swap. However, while holding the currency for seven nights, interest was charged and depending upon your profit, and it is charged and either deducted or added into your account.
This is a simple example of swap short.
Financial trading is not easy. Maybe this is the reason that most of the population around the world is not involved in trading. However, the gains and losses both are huge which can either make you rich in seconds but also broke too.
To end our conversation:
So did you see how many these financial instrument sellers earn money? How small a unit they work on but make millions of dollars. Their major focus is on the number of transactions and quantity in each transaction to make them profitable. This small unit which you cannot even count on your fingertips is called Pip. Pip stands for the point in percentage. Like we know that 1 AUD (Australian Dollars) equals to 0.67 USD (US Dollar), but for them,its 1 AUD is equal to 0.67774 USD. Just think how small this number is.
After this, when you trade or hold a currency for overnight, interest is charged. This interest is the swap rate which every financial instrument has upon which they earn money. This rate is multiplied by the number of pips to commute a dollar amount of interest either charged or paid. Good exchange rate companies always earn interest while those who are in losses pays the interest.
In the swap, we have two kinds of swaps. The swap long and the swap short. It is a misconception that if you hold money for a longer period,it is called swap long and if you hold the money for a shorter period, it is referred as swap short. But this is not the case.
Swap long is the concept which deals with buying the first currency in the pair against the other currency in the pair with the assumption that it will grow over time. Example, if you pair EURUSD so you will buy euros against the dollar in the hope that euro will appreciate against the dollar and will sell them to earn the profit. This is swap long. But when you hold the money overnight, you are either charged or given interest per night this is called swap rate long.
Swap short is the concept which deals with buying second currency in the pair against the other first currency with the assumption it will depreciate over time. Example if you pair AUDJPY so you will buy Japanese yen against Australian Dollars. You will then hold them overnight. If Japanese ye depreciated, you will make a profit and close the deal by selling yen to buy back Australian dollars. This is calleda short swap. But when you hold the money overnight, you are either charged or given interest per night this is called swap rate short.
Remember,the swap rate is charged only when you hold a currency overnight. If the currency is bought and sold within working hours, then no interest or no swap rate is charged.