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What is Forex Overnight Swap and How to use it in Trading?

Forex Overnight Swap

Forex Overnight Swap

Forex overnight Swap is the interest paid to the traders for holding a position overnight. As we all know that each and every currency has an interest rate connected to it. Since Forex trading is done in pairs, every trade involves not only two different currencies, but also two different interest rates. That’s why interest is provided in overnight positions.

Forex Overnight Swap Trading Strategy

Forex Overnight SwapRecently, I found an interesting trading strategy in a forum, designed to futures trading, but theoretically applicable to Forex trading . The author of the strategy claims that even with completely objective and straightforward rules, a strategy “follow the trend” simple and complete operated through a group very diversified markets liquid futures has produced an average of approximately annual return 20% per year over the past two decades, significantly outperforming global equity markets and equating the kind of returns produced by hedge funds (hedge funds) professionally managed futures following the trend.

As a professional Forex strategy maker, I thoroughly investigated to see what kind of margin could have historically provided to retail Forex traders. The results are interesting because they illustrate exactly why it can be so difficult for retail traders exploit margins that exist within the markets.

Forex Overnight Swap Trading Set up

Let’s see the rules of this particular strategy:

  • Risk : ATR (Average True Range, or average true range) should be equal to 1 unit of risk.
  • Input : long at the end of any day close above the highest closing the last 50 days; short at the end of any day close below the lowest of the last 50 days closing.
  • Input Filter : long entries only when the 50 SMA (Simple Moving Average or Simple Moving Average) is above the 100 SMA; short entries only when the SMA 50 days is below the SMA 100.
  • Output : You should use a trailing stop of 3 times the ATR of 100 days from the highest price since the trade opened (for long) or the lowest price opened since the trade was open (for short). The trailing stop should be constantly recalculated as a “stop Spider” ( “chandelier stop”) and should be a smooth stop: output only done when a daily close is at or beyond the stop loss .

How Forex Overnight Swap Trading Works?

This strategy has been proven as the most liquid and popular couple of Forex spot: EUR / USD, during a long and recent time (from September 2001 until the end of 2013), using publicly available data EUR / USD spot with the opening and closing daily at midnight GMT.

Forex Overnight SwapThe results show that the strategy provides a profit margin in the EUR / USD during the trial period. More than 366 trades , a total return of 33.85 risk units achieved, giving an average of positive hope for trade of 9.25%. This means that the average transaction was a risky equal to the amount plus an extra 9.25% of that return. Given that the strategy is completely mechanical and represents only an instrument in what is traditionally the asset class trend – following under performer (currency pairs), this is not a bad result.

However, they must be taken into account commissions and fees when determining the return that could have truly enjoyed. Assuming that trading was conducted by a fund futures contracts EUR / USD, and:

  • A Quarter of trades were subject to “roll over” (Crawling position) before the expiration of the contract, causing an additional fee, and had to pay a commission of “return” of $ 20 per transaction, and what, It was negotiated an account of 10 million with each unit equivalent risk to a fixed 1% of the initial size of the asset, then,
  • The Total return would equal 3,385 billion, less than 366 trades multiplied by $ 25 each, representing the commissions. This would mean a reduction of return of only 0.1%, giving a total return of 33.75%. One might assume that if strategies “roll over” were less than perfect, there would be some additional losses.

Imagine now a retail trader with a $ 10,000 account you want to operate following this strategy, using a retail broker currency. Fortunately for this trader, broker provides access to some kind of closure on a futures contract may be subject to trading with a size very small batch, as well as operating cash Forex with a very small lot, so no problem with scalability.

The next step is to solve some of the likely costs of trading for the retail trader who is trying to implement this strategy in the same period in the EUR / USD. First we can see the cost of using cash Forex:

Every transaction represents a spread of 2.5 pips, and:

Every position is open at the close of New York has a cost of overnight swap varies from one position to another, but more or less equivalent to, say, three-quarters of a pip per night.

For the sake of simplicity we can make an estimate based on pips. The calculation of return of 33.85% was based on a 9088 pips gain. The spread themselves are only 2.5 pips multiplied by the trades 336, equivalent to 840 pips. Then you must deduct the costs of overnight swaps. Our retail trader had an open position for 9889 nights, which is 7417 pips. So we have to deduct a total of 8257 pips of our total profit of 9088 pips, leaving a net profit of only 831 pips!

With this estimate, if we assume that the return is distributed evenly over each pip, this represents a greatly reduced for our retail trader of only 3.09%, compared with the return of 33.85% net profit achieved by the fund 10 million dollars that we saw earlier.

Our retail trader could have an alternative, which would be to buy mini contracts synthetic futures do not incur charges for overnight swaps, but have wider spreads; something like 14 pips per trade for EUR / USD. Taking another look at the numbers and assuming that a quarter of all trades should be subject to roll-over, our retail trader would face 458 times a commission of 14 pips, which equates to a deduction of 6412 pips. This would represent a net profit of 2676 pips. Assuming again that any return is distributed equally in each pip, our retail trader ends with a net total return of 9.97%. So use mini synthetic futures would have been much more profitable, but that would still represent an annualized return on trial period of less than 1% profit per year! Moreover, this return would be less than one third of the amount enjoyed by the large background.

Analyzing the Forex Overnight Swap situation

Why are things so complicated for our retail trader? There are several reasons and careful examination of each can help any aspiring retail trader to understand how they may incur certain margins in the market for a poor choice of broker or methods of execution.

Forex Overnight Swap

Futures contracts are too large to be available to most retail traders and size of the position can not be sufficiently achieved with less than several million dollars in a diversified strategy of monitoring the trend quantities. The mini futures are a possible solution, but if they are not very liquid, then it is unlikely to present the same margin tracking the trend ordinary future. The Exchange Traded Funds (ETFs, for short) are another partial solution, but still, the retail trader will have to pay some kind of spread for access to an appropriate market well above the commission leg and around $ 20 by a major customer of the Futures Exchange.

This brings us to the subject of spreads. Frankly, there is no reason why even a retail trader should be paying more than 1 pip for trade and forth in an instrument such as vanilla as in the EUR / USD. The brokers who charge more than that really have no excuse. I must say that spreads in the retail sector have been declining in recent years. While this is good news, although the retail trader in our example had been paying 1 pip instead of 2.5 pips, this would have increased the profitability only 1.5% extra and can not really be traced up to 2001 no case.

This brings us, finally, the real culprit of the decline in profitability: the overnight rate swap, which is widely misunderstood, and therefore worth a detailed examination of it.

Overnight Swap Charges  

When you perform an trade in Forex, you are actually borrowing a currency in exchange for another.Therefore, logically you must pay interest on the currency you are borrowing, while receiving a return interest on the currency you have. Usually there is a differential interest rate between the two currencies, which means that you could be or receiving or paying an extra fee every night which represents the differential, and, of course, the exchange rate is a factor, since once rare coins are in the parity level, that is 1 to 1. the only time you would not have to pay or receive nothing would be if exchange rates were exactly the same at the time of “rollover” (or drag renewal of the overnight position, that is, the position overnight), and there were no interest rate differential.

It would seem that sometimes you pay the difference and sometimes you receive, so overall this swap is canceled. Unfortunately, it is not as simple as that because of several reasons:

  • The Currencies with higher interest rates tend to rise against the currencies with lower interest rates, so that over time you tend to be in longer trades where you will be borrowing the currency with the higher interest rate, meaning that it tends to pay more to receive.
  • The Retail Forex brokers charge or pay very different rates to their long or short of a particular pair customers.Many brokers are very opaque on this and do not even show the applicable rates on their websites, although rates can be found within the brokerage feed all MT4 platform. It is worth mentioning that, to be fair, there are different legitimate methods of calculating this charge. However, if you look at the compiled in Table myfxbook , showing a wide range of overnight rates (rates per trade remains open overnight) charged by some retail Forex brokers, you get an idea of the variety that exists in the market.

In addition to charging or paying the interest rate differential, some brokers also apply a quota of “management”, which may mean you will not get anything, even when the interest rate differential is in your favor! Ironically, these tend to be the same brokers that charge to account inactivity, and the fact that management is rarely applicable when operating in the real market is very questionable. The end result is to stretch the commissions further to the detriment of the customer.

Most traders are highly leveraged, which means they are borrowing most of the money they are negotiating.Traders tend to forget that one of the negative consequences of leverage is up overnight swap charges, since they must pay interest on any money borrowed, not only by the margin they are putting in that particular trade . Of course, this is an element that is charged legitimately.

The practice of charging a fee for each night that a customer holds a position is not only open to abuse, but it can also be an effective way to dramatically reduce the chances that a trader can try to move things in your favor for intelligent use of trading long-term trend, which usually worth over time if executed properly. You could say that some retail brokerages are using the widespread ignorance about these charges as a way to add more profits to their balance sheets, and that regulatory agencies should take action against these practices. On the other hand, also arguably you can not expect a market-a market maker believes such a market maker- display systematically damaged by the statistical behavior of long-term market. It could be that many of differential rates among brokers were reflected by the currencies of your customers go long or short in a given time. One can see that a broker might be offering a better deal than another in a currency pair, but not another, which seems strange.

The bottom line: Forex Overnight Swap

Let me tell you- this is a very interesting strategy and I am sure more analysts will look on this and try to take corrective measures to make the strategy more powerful. A systematic study of this issue would result in a very interesting read. Meanwhile, a retail trader looking systematically keep overnight positions (open positions overnight) must ensure that thoroughly investigates what they offer you when you are looking for broker and take into account the speed of a price movement in favor of the broker you can have a great effect on the profitability of any trend or momentum strategy that might be using.

About the author

Md Chhali Uddin

Md Chhali Uddin is a Renowned Financial Analyst. He is also involved with Forexing24.com as a writer and financial Analyst. He is a brilliant Financial geek with vast experience in every sector of Currency Trading.

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