In forex trading, rollover is the interest that a trader earns or pays for holding a currency position overnight. Forex are typically traded in currency pairs and as such, each trade is based on two different interest rates.
How Rollover Works in the Forex Market
Many traders consider foreign exchange rolls as set by the central bank. In reality, forex rolls are established through forward points based on the overnight rates applied in interbank borrowing of unsecured funds.
Given that the forex market is, essentially, an over the counter market, trades must be settled or otherwise brought forward to the following day. Traders earn positive rollover in the event that the interest rates they bought their currency pairs on are higher than the rate at which they sell their currencies. The opposite it true—if the interest rate you bought your currencies on is much lower than the interest rate you are selling on, you will incur a negative rollover.
How does rollover practically apply in forex trading?
When you trade currency pairs, you are effectively trading a contract that entails exchanging one currency for another. The contract is expected to be delivered within two business days. So, say you purchase a single contract of USD/JPY; this means that you are buying a certain amount of US dollars and selling the same amount of Japanese Yen. You are required to deliver the said amount of Japanese Yen to the account of the trader you are transacting with. In turn, the party that you are transacting with is required to deliver an equivalent amount of Euros to your account within the requisite two business days.
For example, if you purchase a EUR/USD currency combination, you have essentially sold US dollars and bought Euros. Say you earn interest on the Euros and pay an interest on the US dollars using the amount you have received from the interest earned from buying the Euros. What all this means is that when you sell a currency, you are essentially borrowing this currency and in turn exchanging it for the same amount of the currency you are looking to purchase.
At the end of the day, the interest rates you will pay and receive from the currency trading are worth two days of the interest rates incurred from overnight rates in the country whose currency you are trading.
Remember that when you buy a currency at a high interest rate and sell another currency at a lower interest rate, you will incur a profit for holding this trade after 5pm given that the different interest rates are favoring you. On the other hand, if you buy a currency with a lower interest rate, sell a currency with a high interest rate, and hold this trade beyond 5pm, you will pay an interest. Rollovers are not initiated when a trader enters and exists the market position prior to 5pm.
So, let’s assume the interests rates in the European Union are 2.25% and 1.15% in the United States. If you buy, you would be holding Euros at an interest rate of 2.25% and you would thus be borrowing US dollars at a rate of 1.15%. In this scenario, the interest rate difference is in your favor, allowing you to earn an interest if you hold this position past 5pm Eastern Time.
One the other hand, if you were to sell the same currency pair, it would mean that you are borrowing Euros at a rate of 2.25% and holding the US dollar at a rate of 1.15%. This would require you to pay an interest if you hold this trade position past 5pm Eastern Time.
Rollover is done automatically. What is really important to understand is that positions that are held after the closing of the market i.e. past 5pm will result into a debit or a credit into the accounts of the parties involved in a trade. Trading currencies requires you to pay an interest or to place a credit based on whether you are holding the currency or borrowing.