Interest payment refers to paying a certain percentage on borrowed money or earning a certain percentage on owned money. To illustrate it better, we can take a bank example. If you take a loan from a bank, you will be required to pay an interest rate, but if you deposit a large amount of money into your bank account, you will earn the interest rate. The same rule applies to the interest of margin in the Forex market. Interest is paid and earned on currencies. When a trader enters a trade, he buys one currency and sells another one.
The bought currency is the ownership of the trader, while the sold currency is temporarily borrowed. This means that the bought currency will earn the interest, whereby the sold currency imposes the interest. This is true only for overnight trades. Trades opened and closed within one day neither earn nor charge interest. The interest (paid or owned) is known as “carry” or roll.
Interest Rate and Currency Trading
The interest percentage is associated with the currencies and interest rates related to them. If an investor buys a USD/EUR pair, then the trader gains the interest that prevails in the USA and pays interest according to the EU percentage for interest. If the trader would like to earn, they should own the currency with the higher interest rate, and sell the one with the lower interest rate. For example, if the USD interest rate is at 2.5%, and the EU’s is at 1.2%, isn’t it better to pay 1.2% and to earn 2.5%? This would still amount to earning 1.3% in interest. Now, let’s say that a trader holds the position for a very long time, like a year, they would make a significant profit solely based on the interest rate.
Carry trades (trades held overnight) are regarded as trading strategies in some situations, given the movement of the interest at night. Many try to gain on interest rates, and if they engage in longer trades, they have a fair chance to earn some extra cash. Nevertheless, Forex is not that simple, and it is highly unlikely that the market conditions would be so steady throughout the year. If you add the interest rate spread that brokers charge, you can see that the profit drops significantly. The interest rates vary, and no one expects them to stay the same, especially not for a whole year. This adds up to the risk in the Forex market too, and no one can guarantee a profit from interest rates.
Many Forex brokers pay interest on the amount in your trading account, which is called margin. The rate depends on the broker and the amount in your bank account, which is not used as margin (the part of the leverage that the trader does not borrow). Traders with a margin account borrow money to increase their chances of investment return. Beginners, when signing with a Forex broker, are required to sign up with a margin account. With this account, traders can borrow money for a short period to boost profits. The borrowed money refers to the amount of leverage the broker took.
What is Leverage?
Leverage is the amount that a trader can borrow from their broker to boost their earnings. Different brokers offer different leverages; e.g. 1:200, 1:500, 1:1,000, etc. This means that for every dollar invested you get an additional $200, $500 or $1,000 to invest. The amount you actually and eventually borrow is defined as margin (that is the amount you owe to your broker). This does not mean that you should use up all of the leverage money, but if you take a part of it, you have to pay it back. Traders have to deposit money before they place a trade with a Forex broker with the interest in margin.
The amount of money depends on the agreed margin percentage between the broker and the investor. It is usually not higher than 2%. If a trader wants to trade, for example, $10,000 with a margin of 2%, he only deposits the amount of 2%, while the remaining 98% will be provided by the broker. The interest rate is usually not charged on the borrowed amount, but if the position stays open surpassing the delivery date, then the trade will roll over which could lead to charging interest. The percentage of the interest rate would depend on the interest rate of the currency and whether the trader went with a long or short position. The amount deposited into the margin account represents insurance for the broker. If the position of the trader is heading south, the broker can request an additional deposit on the part of the trader, or close the trader’s position to reduce the trading risk.
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As already seen, the leverages offered by brokers are pretty generous. Margin requirements are very low. This is what determines the great losses and profits in the Forex business, even though the currencies cannot move in price like stocks. Up until recently, the USA was allowing high leverage (1:500), while the policy has slightly changed in 2010 and the leverage has been reduced to 1:100. The leverage has been reduced to limit the risk of margin. High leverage can drive traders easily into debt, when they overuse the leverage to back up their trades. Even if European and other offshore brokers still offer higher leverage, US traders are not allowed to take advantage of these opportunities and many overseas brokers do not leverage Americans with a ratio over 1:100.
Forex brokers with interest of margin are the ones who pay the interest on the leverage untouched by the trader. As we have seen, margins do not usually come with an interest rate until a trader disregards the expiry time of a trade. Leverage has two sides; it can either enhance traders’ chances to return their investments or drive them into debts. Still, brokers try to control the leverage and trading risk by requiring a deposit as a security measure. We have seen in this review how interest rates work and how some profit could be squeezed just out of interest, but other factors play a significant role too, keeping interest earnings limited.