In the last section of this tutorial you learned how you could boost your returns by using leverage. Now we’re going to show you how this leverage actually works, and the costs and gains that come with levered forex positions. These costs or gains are known as forex rollovers, or carry interest.
We said previously that when you use 50:1 leverage you put up $1 and the broker adds in the other $49 for a total investment of $50. When you use leverage, you are essentially borrowing money to invest in the forex market from your broker.
Rollovers
Traders “rollover” their position when they hold them overnight. Holding a position overnight is usually defined by holding them past the closing time for a particular broker, which can range from 4-6pm EST.
When you use leverage through the day, you are essentially borrowing money for that day. If you wish to hold the position overnight, then you’ll either gain or lose interest by doing so. Alternatively, traders who do not want to pay interest on their holdings can do so by selling before the day closes. Most forex brokers do not charge or add interest for holding a leveraged position through the day.
Always make sure you fully understand how your broker calculates rollovers and carry interest before you start trading! Some calculate interest per hour. Others calculate the interest every day at a specific time.
Simple Interest Mathematics
We’re going to have to use some quick mathematics to see how forex traders earn or pay interest on margin trades. This is very easy, though!
Previously, you learned that when you buy or sell (go long or go short) a currency pair you are swapping one currency for another. You are buying one currency with another currency, or selling one currency for another currency.
There’s a very simple way to conceptualize each transaction. Imagine you are borrowing from one bank to deposit the money in another. If you were to go long USD/CHF for 10,000 units, then you would be swapping Swiss Francs for $10,000. Thus, you would be borrowing Swiss Francs from a Swiss bank, and lending Dollars to a US bank.
Let’s say the borrowing rate for Swiss Francs is .25% per year, and the lending rate is .5% per year for US Dollars. If you were to long the USD/CHF pair, you would pay .25% interest in Francs, and earn .5% interest in Dollars. A long position would earn you .5% interest in dollars per year cost you .25% interest in Swiss Francs. Your net gain is .50% minus .25%, or .25% per year!
If you were to sell USD/CHF, you would pay .50% per year to borrow Dollars. You would gain .25% from lending the Swiss Francs. Your net interest cost is .25% minus .50%, or -.25% per year.
Carry Interest Example
Let’s say you bought the USD/CHF pair to hold it for one year. Over the course of the year, you would have an interest expense of $25 from CHF borrowing, and a $50 gain from USD lending. The net gain would be $25 just for keeping the 10,000 unit position open for one year!
We can divide this by 365 to get a gain of $.06 (6 US cents) in interest each day. So, if you hold a 10,000 unit USD/CHF position for one week, your gain would be $.42 in interest. That does not include the currency fluctuations, just the interest on the margin, or leverage.
All things considered, the cost of carry is very small for many pairs, and hardly affects your trading balance — positive or negative. In future tutorials, we’ll explain how some traders make predictions about the forex market by using interest rates as a guide, and how others make their living just by accumulating rollover interest in the forex market.
Sound like a plan? Continue on!
