When trading forex, it is crucial to understand what overnight financing is and how it works. Overnight financing is the cost of holding an open position overnight and is calculated as the difference between the interest rates of the two currencies involved in the trade. For example, if you are long EUR/USD, you will be charged overnight financing if the interest rate on EUR is lower than the interest rate on USD. The amount of financing charged or earned will depend on your position size and the interest rate differential.
Overnight financing can significantly impact your trading account, especially if you hold positions for extended periods. It is essential to factor in the cost of overnight financing when making trading decisions. Some brokers offer account types that do not charge or earn interest on positions, so check with your broker before trading.
How is overnight financing calculated?
Overnight financing is calculated as the interest rate differential between the two currencies involved in the trade. The amount of financing charged or earned will depend on your position size and the interest rate differential.
For example, if you are long EUR/USD and the interest rate on EUR is 0.50% lower than the interest rate on USD, you will be charged 0.50% overnight financing. If you are short EUR/USD, you will earn 0.50% overnight financing.
Traders can use the following formula to calculate the amount of overnight financing charged or earned: Position size * Interest rate differential / 365
Where:
- Position size = number of units traded
- Interest rate differential = difference between the interest rates of the two currencies involved in the trade
- 365 = number of days in a year
For example:
Assume you are long EUR/USD and the interest rates are as follows:
- EUR interest rate = 0.50%
- USD interest rate = 1.00%
- Interest rate differential = 0.50%
- Position size = 100,000 units
Overnight financing charge/earn = 100,000 * 0.50% / 365 = 14 USD per day.
Risks of overnight financing
Overnight financing charges can eat into your profits
If you hold a losing position, the interest charged on that position can add to your losses. For example, if you are long EUR/USD and the pair is trading at 1.1150, you will be charged interest on your position based on the interest rate differential.
Overnight financing can lead to margin calls
If the interest charges on your positions exceed the available margin in your account, you will receive a margin call from your broker. A margin call demands additional funds to be deposited into your account to cover the losses incurred.
Overnight financing can cause you to lose sleep
Traders should not take the risks of holding a position overnight lightly. If you are worried about the potential losses you could incur, it might be best to close your positions before the end of the day. This way, you will not have to worry about the market moving against you overnight.
Why do traders use overnight financing when trading forex?
To avoid paying taxes on gains
In some countries, profits from forex trading are subject to capital gains tax. However, if the profit is generated from overnight financing, it may be exempt from capital gains tax. It depends on the country’s tax laws, so checking with a tax advisor before trading is essential.
To hedge against currency risk
Some companies in foreign countries use overnight financing to hedge against currency risk. For example, a company importing goods from the European Union might hedge its currency risk by taking a long position in EUR/USD.
What should forex traders consider before using overnight financing?
The interest rate differential
When considering whether to use overnight financing, traders should look at the interest rate differential between the two currencies involved in the trade. The interest rate differential will determine how much financing will be charged or earned on the trade.
The size of the position
The position size is another factor to consider when using overnight financing. The larger the position, the more interest will be charged or earned.
The available margin
Before using overnight financing, traders should ensure they have enough margin in their accounts to cover the potential losses from the trade. If the losses exceed the available margin, traders will receive a margin call from their broker. Saxo allows you to use overnight financing, check it out here.