Swap And Leverage In Forex Trading | Full Details

In the previous lesson we talked about commissions, we got to know that commissions are the fees that your broker charges you. In this lesson, we take a look at the meaning of swap and leverage in forex.

So what is a swap in forex trading?. Well there is one more fee that a broker will charge you which is called a swap fee.

Whenever we borrow money from someone, we have to pay back with interest. Whenever we loan an amount to someone, we charge interest on the loan amount. 

Let’s say you have a friend called Dan and he borrowed you $1000 with a 5% interest. Then you deposited that amount in the bank and the bank is willing to give you a 4% interest on your money borrowed. 

In this case, you’ll have to pay 1% to your friend as the difference between the interest rate of both parties. Now what if Dan gave you a $1,000 loan at an interest of 4% and your bank gave you an interest if 5%?

In this scenario you will receive 5% from the bank out of which you’ll give 4% to Dan, and you will be left with 1%. This is how the swap fee works as well.

In the forex market, the swap fee is the difference between the interest of two currencies involved in a currency pair.

Whenever you hold a trade, you are either charged or paid and that is called a swap. In more technical terms, a swap fee is a charge or interest that your broker charges or pay you for holding trading positions overnight to the next trading day.

The broker charges or pays you a specific amount of commission depending on the interest rate difference between the two countries involved in the transaction on its direction if you are buying or selling, and the quantity of the number of units you are buying or selling

In a more simplified way, whenever you hold a trade overnight, your broker charges you with a fee or pays you interest for that trade. If the broke will charge or pay you, it will depend on certain factors like: 

1. The currency pair you are dealing with
2. Your account currency
3. Interest rate of both
4. The direction of your trade ( whether you are buying or selling)
5. The number of units you buy or sell
6. The markup fee of your broker.

Now let us try to understand the idea behind swap.

How does swap work? (Swap and leverage)

Every currency in the world has its own interest rates and these interest rates are managed by the central banks of the respective countries to which the currency belongs. Hence, it’s used to manage the economy of the country 

You might have seen that the are different financial news going on in the forex sector. These are the interest rates that are decided by the central banks of the respective countries to countries. 

These are normally dependent off the economic situations. So whenever you hold a currency, you get interest on it.

Now whenever you buy or sell anything in the forex market, there are two different currencies involved as we have discussed in your previous lessons.

These currencies will have or come with their own interest rates. According to  the rules, you can hold a currency for a day without any interest charge but, as the new trading day starts, you’ll be charged with or gain interest of the difference of the two currencies you are involved with. That’s what we call a swap fee.

If you have a little idea about forex then you must have heard that you can start your forex trading from as low as ten dollars or you may have seen people making thousands of dollars from accounts as low as $50. 

So how is it possible because with such a small account, you cannot even open a trade with even one micro lot. But how is it possible? Well, leverage is the key to that and in this lesson I will explain to you what it is.

What is leverage in forex trading? (Swap and leverage)

Leverage is nothing but the amount of money a trader borrows from the broker to increase the profit potential. Let us try to understand this with the help of an example.

So let’s say you funded an account with $1000 and your broker provides you no leverage. This means that you’ll have to trade with the leverage of one is to one (1:1). This means that with that account you can buy or sell only 1,000 units of any currency pair and you cannot borrow any money.

With that said, if you bought 1000 units of USD/JPY, that means you used one micro lot size (0.01). Let’s consider you bought this 1000 units 110.00 and then the price moved to 111.00, it means the price moved 100 pips and you have a profit of $10.

As with one micro lot size, one pip is equal to $0.01. Now let’s assume that you had the leverage of 1:10 on your $1000 account. This means that your broker allows you to use 10 times more money that you have in your account.

Your broker lets you control as much as $10,000 with a $1,000 account. With this you can buy 10,000 units in any currency pair or use one mini lot size with the same amount of one thousand dollars. 

If you buy 10,000 units of USD/JPY at the price of 110.00 and the price moved to 111.00, it means that the price moved 100 pips which has made you a profit of $100 as with one mini lot size, one pip is equal to $0,10. 

In simple terms, leverage means borrowing from your broker. When you have a one thousand dollar account and a leverage of 1:10, then you can buy or sell 10,000 units or control $10,000 from your account.

It’s the same scenario if you have a one thousand dollar account and your leverage is 1:100, you can buy or sell 100,000 units or control 100 times more money on your account or use one standard lot size. 

There must be one question that might be running through your mind which is:

Why does the broker let you borrow money? 

There is a really simple and straightforward answer to this. Your broker earn money when you trade more and therefore a broker wants you you to trade more.

Also the broker puts your initial deposits aside and as soon as all your trades are lost reaching the initial account balance, the broker will not go negative.

for example, with an account of $1,000 with a leverage of 1:100. If you decide to open a trade with one standard lot which is 1.0 at the price of 111.00 and the price moves to 110.00, this means you had a loss of 100 pips.

For a one standard lot size, 100 pips is equal to $1000. As your account was in a loss of $1000,  your account will get flushed or you will lose $1000. You can clearly see that leverage is helpful. 

It can help you make good profits but it may also make you lose your account in a single trade. With that noted, the trader needs to choose their leverage correctly.

What is the prefect leverage?

Well, traders use a leverage of 1:10 to 1:50. This is also because of the account size. If you have an account size ranging from $50 to $5,000 then you can go for the leverage of 1:100 and if you have an account size greater than $5,000, then you can choose a leverage of 1:50. 

Just make sure you don’t risk more than three to five percent on a single trade. I hope you have understood what leverage in forex trading is. If you have any doubts or questions, feel free to ask in the comments section below. 

If you missed the previous lesson, there is a link below to help you understand why we are here and also, if you want to access the full course, we have placed a link to that below as well

Previous class: What Is Commission In Forex Trading? | Full Details

Full course: Forex for beginners