Foreign Currency Trading Education – An Explanation of Rollover

 

Newcomers to foreign exchange trading can be bewildered by an array of new terminology that makes learning Forex trading a little daunting. One concept that can confuse new traders is rollover. In this article we are going to explain the idea behind Forex rollovers, how they are calculated and what this means for the average trader.

A foreign currency trade involves the simultaneous purchase of one currency and the sale of another currency in what’s called a “currency pair”. The size of each transaction is related by the current exchange rate so that one transaction is balanced by the other.

Since Forex pairs are traded in units down to 4 decimal places, accounts are usually leveraged – traded using margined accounts. The reason is simple – the exchange rate for most currency pairs will usually move in the order of 1% per day. Since many Forex trades are conducted using short term trading, the trader must leverage his funds to control a larger investment amount and increase his return on capital.

A standard lot size or standard contract with most brokerage firms equates to $100,000. Leverage on your Forex account varies from around 50:1 (2% margin) up to the higher levels of 200:1 (0.5% margin) or more which allows a trader to control a standard lot using only $500 of their own funds.

For example, buying 1 lot of the AUD/USD currency pair would actually involve buying AUD $100,000. The purchase of this AUD lot would be offset by a simultaneous sale of USD currency. The amount of currency sold would be calculated such that the value of the USD side of the trade is equal to AUD $100,000 at the time the trade is made.

If our account uses 1% margin and the current exchange rate was 0.9000, our broker would set aside $1000 from our margin account as the “used margin” for this trade. Our account would then be long AUD $100,000 and short USD $90,000.

Our contract with the broker is such that they will pay interest on the currencies that are held “long” in your account and charge interest for the currencies that are “short”. The rate of interest is usually the base interest rate for that currency with a small fee differential. This fee will depend on a number of factors such as your account leverage and lending rates amongst others. Check your broker’s contract for details in relation to your account.

In our example above, if the base rate for AUD was 3% and the rate for USD was 0.5%, we would be paid interest on AUD $100,000 at a rate slightly lower than 3% per annum and charged interest on the USD position at a little above 0.5% per annum. In this case we would actually earn interest on our position.

However, there is one last complication. Since the Forex market is a 24 hour market, when does our interest period start and finish? What about positions that I hold for less than a day? As it turns out, interest is neither earned nor charged on your account unless your trading positions are open at your broker’s “cut-off time” (usually 5pm in New York).

If your position is open at that time you will be credited or debited one day of interest on your open amounts. This is true whether your trade has been open for one minute, one hour or two weeks. If your trade is closed at cut-off time you will not be charged interest for that day regardless of how long your trade was held for.

Understanding margin and rollover is an important part of your trading education. Unless your position sizes are very large you are unlikely to get rich off the interest. However, at least now you will understand your brokerage account statement completely.

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