What is swap in forex trading?

I am in forex trading for some days now and I have decided to start writing about the basic concepts and terms involved with this business. Anyone who has traded forex markets using one of many trading platforms available, must have come across something called as “swap.”I am not sure I myself understand this completely but I am going to try and explain it in layman’s terms whatever I know.

So what is swap? First thing I guess we need to understand here is that swap comes into picture because the financial institutions who actually hold the forex currency lots need to close every open position they have on their books before end of every trading day. Why do they have to do this? I don’t know. If I have to guess, I will guess that it is some sort of trading regularion or global norm. If you think of it, it makes sense too. If the institution is closed for some time (mostly overnight), it must be risky to hold that position open. Also, somewhere I read that they have to do this to fund their trading balances. I don’t think I understand what that means but looks like they have to actually settle the trades and pay the folks they need to pay who have actually placed this trade with them.

But in any case, the fact is the open positions are closed and re-opened the next day.

So whenever any financial institution has to close the open positions, they basically end up doing two things:

  1.  Immediately sell the open position and
  2. Open the same one with some future rate (when the institution is going to open up for trading again)

The first one is called as ‘spot’ trade and second one is called ‘forward’ trade transaction. Some institutions are known to forward-forward trades which means both the transactions are done for a future trading date.

When the financial institutions do this, they have to either pay or receive certain amount of interest on their balances. This amount is called as swap.

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Risk warning: Before deciding to participate in the Forex market, you should carefully consider your investment objectives, level of experience and risk appetite. Most importantly, do not invest money you cannot afford to lose. There is considerable exposure to risk in any off-exchange foreign exchange transaction, including, but not limited to, leverage, creditworthiness, limited regulatory protection and market volatility that may substantially affect the price, or liquidity of a currency or currency pair. More over, the leveraged nature of forex trading means that any market movement will have an equally proportional effect on your deposited funds. This may work against you as well as for you. The possibility exists that you could sustain a total loss of initial margin funds and be required to deposit additional funds to maintain your position. If you fail to meet any margin requirement, your position may be liquidated and you will be responsible for any resulting losses.