In this section we’re going to consider rollover. This is where the world of money meets the world of interest rates, and you will be delighted to know that all of what I am about to describe, happens automatically. In fact, if I didn’t tell you about it here, you probably wouldn’t even now it was happening. But, there is a reason for understanding how and why this happens and it’s called profit and loss, and your overall P & L on your trading account. In addition, and even more importantly, there is a trading strategy that takes advantage of this mechanism, and that’s the ‘carry trade’.
within your account as a result. Rollover as the name implies, is when a contract rolls over into a new period, and in the futures market this happens regularly as traders move from one contract period to another, as each contract reaches expiry.
Naturally this comes at a price, but it allows a futures trader to continue to hold an existing position for a longer term, by simply rolling it over into the next monthly or quarterly cycle. It’s just like renewing your gym membership for another quarter. You pay a renewal fee and your membership is updated for another period, but in the case of the financial markets there is an ‘extra’ price to pay.
Now in the spot forex market we have a very similar system. Here this happens daily at 5.00 pm Eastern Standard Time in New York. Suppose you have opened a position during the day, and it is still open when it reaches 5 pm in New York, then your broker will automatically ‘roll this contract over’ into the next day.
Your gym membership has just been renewed for a further twenty four hour period, and your forex broker will continue doing this until you tell him or her to stop - by closing the position!
The question you are probably asking is why does this happen and what impact does it have on your account. Let me try to explain.
In the spot forex market this is where currencies are bought and sold, and then settled with the currency then being moved from A to B, and in order to allow all this to happen in an orderly manner, settlement of any contract takes place within two working days. This allows the various parties to transfer the currency from one to another. In other words, everyone’s obligations under the terms of the contract are met. The seller has delivered the agreed amount of currency to the buyer. There is one contract that settles in a day, and that’s the USD/CAD, but for our purposes, let’s just assume it’s two days.
Assume it is Monday morning, and you have opened a position in the spot forex market. If this is then closed before 5 pm New York time, settlement of the contract would take place by Wednesday 5 pm EST. However, if you had left this position open, then at 5 pm EST it is rolled over, and immediately becomes a contract of Tuesday which has an associated settlement date of Thursday. Likewise, if you leave it open on Tuesday then it is rolled over into a Wednesday contract. But on Wednesday at 5 pm EST things change, and the
settlement date is rolled to Monday, which means a three day rollover cost to allow for the weekend.
In simple terms this means the cost of rollover is three times as much. And so the cycle continues until the position is closed. Now at this point you might be saying, ‘well this is very interesting, but if it is all happening automatically, why should I know or care?’
The answer is this. Each time a contract is rolled over to the next day, there is a cost involved to one party or another, and the position will either earn you interest, or you pay interest. This is because rollover is the point at which two things happen.
First, your position in the market is rolled over into the next day so that your contract remains open, and second the interest rate earned, or to be paid on the position, is calculated and either debited from your account, or credited to your account. And because forex is traded in pairs, every trade involves not only two different currencies, but also two different interest rates as well.
You can think of it as having two separate bank accounts in two countries, with different currencies in each. We are trading real money here after all!
If the interest rate on the currency you bought, is lower than the interest rate on the currency you sold, then you will have interest to pay, and is called a negative rollover. However, if the interest rate on the currency you bought, is higher than the interest rate on the currency you sold, then you will earn interest on the position. This is where the carry trade becomes a speculative trading strategy for many traders, who look for the maximum interest rate differential between two currencies, which then accrues every twenty four hours.
Let’s look at how this works in practice, with a simple example, and remember that if you are keeping positions open over the weekend, then the rollover costs will be roughly three times those during a twenty four hour period.
I want to try to keep the maths as simple as possible here, and also bear in mind that interest rates are at historically low levels around the world, so the cost of the rollover in the last few years has been very low. But equally, any credits have also been poor and even the carry trade has only be able to achieve a maximum differential of around 4.5%, which is why many traders have sought out the exotic currencies for higher yields. This will change as inflation rises, along with interest rates and rollover costs, and they will not stay
low for ever.
Here is a simple example with the EUR/USD using a mini lot with an exchange rate of 1.4500, and an interest rate of 1% for the euro, and 0.5% percent for the US dollar.
Suppose we have bought the contract, and are therefore long euros and short dollars, and just to make the maths simple, we are going to assume we hold this for 1 year! An absurd time, but it just helps to make the maths a little easier. I have also assumed for simplicity, that the exchange rate is the same at the start of the year as at the end of the year, and this will almost certainly not be the case! But this is just to show you how the interest rates work.
Our 10,000 euros over a year would earn us: 10,000 x 1/100 = 100 euros
On the other side of our position we have $14,500 US dollars, which would be costing us:
14,500 x 0.5/100 = $72.50
If we were to hold this contract for one year and roll it over day after day then at the end of the year we will have earned, 100 euros on the euro balance, and paid $72.50 dollars on the dollar side of the position. Now if we convert the euro earnings back to dollars using the 1.4500 exchange rate, then this becomes $145 on the euro side of the contract, which is in our favour.
In short, we have earned $145 and in earning that interest, this has cost us $72.50. So a net credit of $145 - $72.50 = $72.50.
Here we bought the higher interest bearing currency, the euro and sold the lower yielding currency, the US dollar. This is over an entire year so converting this to a daily dollar rate, we simply divide by 365, and we get 0.20 or 20 cents per day.
Not a lot you might say, which is true in this case, and you probably wouldn’t even notice it in your account, as this all happens automatically at 5 pm EST. However just let me highlight some issues here for you. First, at the moment we are in a period of ultra low interest rates and therefore in this case, which I
chose deliberately, the interest rate differential between these two currencies is very small at 0.5% and reflects the current situation. This is not going to last forever, and at some point soon rates will begin to rise. What happens if the economy in Europe begins to expand faster than that in the US?
Let’s assume interest rates in Europe are now 4% and in the US are 1%, still using one mini lot and the same exchange rate.
In this case we would earn 400 euros on our base currency and be paying $145 on our counter currency, and converting everything back to dollars, gives us a net gain in interest of:
$580 - $145 = $435
A total of $435, which converts to a daily credit of $1.20. This is great if we are long the contract, and the position is going in our favour, and herein lies the problem which many forex traders forget.
Earning interest on a position that you are holding for the longer term may sound very attractive, and in some cases it is - but there are always two sides. You may well be earning interest, but if the position is deep in loss, the fact that you have earned a few dollars will be neither here or there. The message here is clear and simple. Focus on the pair and the direction of the currency pair, and not on the underlying credit or debit on your account. Get the direction right and the profits will look after themselves. Too many forex traders focus on trading positions to take advantage of the credit on rollover, which is a big mistake. My purpose here has been to explain what it is, and why it happens, and simply to be aware of this which all occurs automatically in your account. The carry trade is one specific strategy that harnesses this aspect of currency rates, and interest rates, but is generally based around the Yen currency and particularly with the Australian Dollar. There are many other high yielding currencies around the world such as the Mexican peso, and the Brazilian real to name just two, but these are extremely volatile and not for the novice trader. Of course, get it right and it’s a double whammy of interest rate credits and profit on the position. Get it wrong however, and the interest rate credit will become incidental!
Now in the above examples we only chose a mini lot. If we were trading a full size lot then we simply multiply by ten, and so in the last example we would be earning or paying $12 a day on this contract.
Finally, do not expect your broker to charge you central bank rates, he won’t, and what you will find is that the interest that you pay always seem higher than you expect, and interest that you earn always seems lower than you expect. Why?
Well, just like a bank your broker is going to make money from financing your trading, so the rates he charges will already have a profit or margin built in, so he will be making money on the spread as well as on interest rates quoted. Your broker, may, if he’s generous pay you a small amount of interest on the balance in your trading account, but generally they don’t, and to be honest the rates are so low it really isn’t worth worrying about at the moment. Rollover however can get expensive when the differential is high, which is why the carry trade is so popular.
In summary, that’s how rollover and interest rate differentials can work both for you, and against you, but these calculations will be going on daily in your account and often unbeknown to the trader. Be aware of it however, particularly if you are trading in multiple lot sizes and holding positions over longer periods