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Why Forex Traders Should Pay Attention to Swap Rates

Why Forex Traders Should Pay Attention to Swap Rates

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swap rates

On the bottom of your MT4 trading terminal, under the trading tab, you’ve likely noticed a column that says “swaps”. At Orbex, you can also find these available on our website. If you are a day trader, you probably just ignore it, because it doesn’t impact your trading. If you are a swing trader, you might have taken into consideration the cost (and sometimes profit) that the swaps add to your trade.

All that is fine, but what if there was some interesting information in there that could tell you where currency pairs were headed? Granted, for day traders – and especially scalpers – this might not be as useful as for swing traders. But, if you pay attention to swap rates, you might get some insight into which currencies are under buying or selling pressure compared to others.

Getting the data

Now, the swap rates on your platform factor in other things, are typically set daily. So, the platform itself might not be the best source of information. Rather, the concept can be very useful to understand, and then you can find the best source of information to suit your trading style.

What are swap rates?

Here’s the thing: When you are trading on margin, you are acting with large amounts of money. Multiple of the amount you have in your account. Large enough sums that just keeping them in cash is a bad idea, because you use value through inflation, and opportunity to make money in interest. A lot is 100,000 units of a particular currency. In dollars, an interest rate of 5% on one lot is an annual $5,000. We don’t want to miss out on that.

So, when you trade a currency pair, effectively you buy one currency and sell another. To do that, you must “borrow” money to sell, on which you pay interest. And then you can “deposit” the money that you bought, on which you are paid interest. The difference between those two numbers is the “swap” rate. (The rate on your platform includes a few other things like commissions and adjustments, but we’re after the concept here).

How does this impact Forex?

Let’s take the EUR/USD for reference. The base interest rate set by the Fed is 5.25%. For the Euro, it’s 4.50% (at the time of writing; the whole point of central bank policy is to change those rates, so let’s just go with those numbers for now). The interest rate paid on deposits generally reflects those differences, though it usually is a bit different due to market factors.

What that means is if I have Euros in my account, I can get paid 4.5% a year. If, instead, I hold dollars, I can get 5.25%, a 0.75% improvement. If we’re talking about just one lot, that’s a difference of over $750. That’s a decent amount of money to make for simply having it in dollars instead of euros. And most businesses, large banks, trading houses, etc. know this. Also, they are handling way more than just one lot, making the math even more favorable towards picking the right currency to hold cash in.

How this moves currencies on the daily

Which is why when the interest rate in one currency rises compared to another, then there is typically a flow of cash into that currency from the other. That will make the currency pair go up or down depending on which of the currencies is favored by the spread.

The thing is this interest rate isn’t fixed. It varies depending on the yields offered by bonds. Because when an entity holds a large amount of cash, they hold it in the form of bonds. When bond yields rise, this is the interest rate that affects the swap. Bond yields vary by minute, but deposits are generally “settled” overnight. That means each day one currency might have a more attractive interest rate than the other. Thus, paying attention to the gap in bond yields between currencies – that is, the swap rate – can give some insight into how currencies move.

Stay tuned for next week’s article when we go over some ways to apply this new knowledge to your trading.

The post Why Forex Traders Should Pay Attention to Swap Rates appeared first on Orbex Forex Trading Blog.

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