Most people are familiar with the basic concept of foreign exchange or forex trading. You buy a currency pair if you think its value will increase relative to the other currency in the pair and sell it if you think its value will decrease.
However, a few different concepts are essential to understand if you want to succeed in forex trading. One of these is a forex swap. A forex swap is an essential financial tool traders use to manage their positions.
This article will discuss what forex swap is, how it works, and the benefits of using it. We will also explore some of the key risks of this type of trade. So, if you are curious about forex swaps and would like to learn more about them, then keep reading!
Forex Swap And Its Working
A forex swap is an over-the-counter financial transaction that allows traders to change the original settlement date. This can be beneficial when trying to maximize potential profits and mitigate losses.
When you enter into a trade, the currency pair’s price in question will change in value when it takes for your broker to settle your trade. You could end up losing money on the transaction if the price of the currency pair in question moves against you before your broker settles it.
A forex swap allows traders to alter their settlement date for a fee. This fee is usually calculated as a percentage of the total position value. You can also close out an open swap transaction before the settlement date of the contract.
However, this means you will be charged an early termination fee of usually another tiny percentage on top of the initial fees for establishing the swap in the first place.
Example of Forex Swap For Better Understanding
Imagine that you decide to open a contract by purchasing EUR/USD at the current market price of 1.3945 with a settlement date of three days from now. However, you are concerned that by this time, your contract may have lost potential value due to the ongoing Brexit negotiations between the UK and EU.
Therefore, you can establish a swap agreement for 10% of the position value to mitigate your losses or maximize your profits. It means that you will pay a $139 (10% of the total contract value) fee and receive the settlement date in three months.
If your currency pair trades between 1.3945 and 1.4020 over this period, then you will have paid $139 to gain $41.55 potentially. As you can see from this example, forex swaps are a helpful tool when trading. However, there are also some risks associated with establishing these agreements.
For instance, by entering into a swap agreement, you will be opening two positions – one long and one short. It means that if the market moves against you on the settlement date of your contract, you might lose more than if you had not entered into a swap agreement in the first place.
Therefore, it’s essential to carefully perform due diligence on your positions before establishing forex swaps.
Why Use A Forex Swap?
Forex swaps are advantageous because they allow you to alter the original settlement date on your contract for a fee. This can be helpful when trying to maximize potential profits and mitigate losses. Also, there is no limit on how many times you can establish or terminate forex swaps on the same currency pair.
While forex swaps are proper financial instruments to access, there are also some risks associated with using them. If the market moves against you before your settlement date, then you may end up losing more than if you had not entered into a swap agreement in the first place.
So, it’s essential to carefully perform due diligence on your positions before establishing forex swaps and to weigh up all risks associated with these types of transactions.
Types of Forex Swap
There are two types of swaps – spot and forward. A spot swap is an agreement to trade a currency pair on the current settlement date at a rate agreed upon by both parties when the contract was established.
The spot exchange rate is different for each forex broker, but one pip or tick usually equates to 0.0001 in the quoted currency.
For example, if your swap rate is 1.4000, this means that one tick or pip in the quoted currency will be equal to $10 and that each time the exchange rate moves one pip or tick, then you will either gain or lose $10 on the value of your contract.
A forward swap works by trading a currency pair on a future settlement date at a rate agreed upon by both parties when the contract was established. Forward swaps usually cost more than spots traded on the interbank market.