Forex Trading: Understanding Rollovers And Interest Rates
Many traders and investors come to the foreign exchange market with a knowledge of
how to trade the stock market, and while much of this information is relevant to currency trading one concept that does not exist for stock trading is that of rollover orders. The rollover is something that is very important for trading the spot forex market, and indeed the forex market could not function the way that it does without this.
When you are trading a physical commodity such as oil on the commodity market, there is a very good chance that you are not interested in having large barrels of crude oil delivered to your front door but instead you are trading or betting on the price of oil on the open market with the belief that the price will increase or decrease. In the same way, when you get a signal on your price chart that you should buy EUR/USD you are probably not interested in having a stack of Euro notes delivered to you, but instead you are betting that the value of the Euro will increase relative to the US dollar and so your open position will gain in value. In order to make sure that you never need to take physical delivery of the currency you are trading, the rollover order comes into play and it is a credit or debit on your open position that is calculated as a factor of the interest rates on both of the currencies you are trading.
It is important not to lose sight of the fact that in the foreign exchange market you are literally trading cash, and cash earns interest. If you had money deposited in a savings account you would expect to earn interest, and if you borrowed money for a loan you would expect to pay interest. In this same way, when you buy or sell a currency pair you will earn interest on the currency you are buying and you will need to pay interest on the currency that you are selling. The way that the rollover order is calculated has to do with the difference between the interest rates of the two currencies you are buying and selling.
If you are buying the currency with the higher interest rate you will earn from the interest rate rollover, and if you are selling the currency with the higher interest rate there will be a deduction from your open position. In this way you can literally keep a foreign exchange transaction open indefinitely while continuing to simply bet on the relative value of the two currencies to each other without ever needing to accept the actual physical currency as you might need to for a foreign exchange transaction at the airport or the front desk of a hotel in a foreign country.
If you understand this concept of the interest rate rollover to keep a position open indefinitely, then you might have noticed that profit potential exists if there is a large discrepancy between the interest rates of the two currencies. If the currency you are buying has a rate significantly larger than the one you are selling, the gains added to your open position could be significant if you hold the position open for a number of days. Indeed this is so, and this is a strategy called the carry trade where you buy the currency with the higher interest rate and sell the currency with the lower rate and pocket the difference, keeping in mind that a move in the value of the two currencies in the opposite direction of your trade could negate the profit earned.
by: Ricky Weber
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