In the
past, spot forex was traded in specific amounts called lots. The standard size
for a lot is 100,000 units. There is also a mini, micro, and nano lot sizes
that are 10,000, 1,000, and 100 units respectively.
|
Lot
|
Number of Units
|
|
Standard
|
100,000
|
|
Mini
|
10,000
|
|
Micro
|
1,000
|
|
Nano
|
100
|
As you
already know, currencies are measured in pips, which is the smallest increment
of that currency. To take advantage of these tiny increments, you need to trade
large amounts of a particular currency in order to see any significant profit
or loss.
Let's
assume we will be using a 100,000 unit (standard) lot size. We will now
recalculate some examples to see how it affects the pip value.
2. USD/CHF
at an exchange rate of 1.4555 (.0001 / 1.4555) x 100,000 = $6.87 per pip
In cases
where the U.S. dollar is not quoted first, the formula is slightly different.
1. EUR/USD
at an exchange rate of 1.1930 (.0001 / 1.1930) X 100,000 = 8.38 x 1.1930 =
$9.99734 rounded up will be $10 per pip
2. GBP/USD
at an exchange rate or 1.8040 (.0001 / 1.8040) x 100,000 = 5.54 x 1.8040 =
9.99416 rounded up will be $10 per pip.
Your
broker may have a different convention for calculating pip value relative to
lot size but whichever way they do it, they'll be able to tell you what the pip
value is for the currency you are trading is at the particular time. As the
market moves, so will the pip value depending on what currency you are
currently trading.
What the heck is leverage?
You are
probably wondering how a small investor like yourself can trade such large
amounts of money. Think of your broker as a bank who basically fronts you $100,000
to buy currencies. All the bank asks from you is that you give it $1,000 as a
good faith deposit, which he will hold for you but not necessarily keep. Sounds
too good to be true? This is how forex trading using leverage works.
The
amount of leverage you use will depend on your broker and what you feel
comfortable with.
Typically the broker will require a trade deposit, also known as
"account margin"
or "initial margin." Once you have deposited your money you will then
be able to trade. The broker will also specify how much they require per
position (lot) traded.
For
example, if the allowed leverage is 100:1 (or 1% of position required), and you
wanted to trade a position worth $100,000, but you only have $5,000 in your
account. No problem as your broker would set aside $1,000 as down payment, or
the "margin," and let you "borrow" the rest. Of course, any
losses or gains will be deducted or added to the remaining cash balance in your
account.
The
minimum security (margin) for each lot will vary from broker to broker. In the
example above, the broker required a one percent margin. This means that for
every $100,000 traded, the broker wants $1,000 as a deposit on the position.
How the heck do I calculate profit and loss?
So now
that you know how to calculate pip value and leverage, let's look at how you
calculate your profit or loss.
Let's buy
U.S. dollars and Sell Swiss francs.
1. The rate
you are quoted is 1.4525 / 1.4530. Because you are buying U.S. dollars you will
be working on the "ask" price of 1.4530, or the rate at which traders
are prepared to sell.
2. So you
buy 1 standard lot (100,000 units) at 1.4530.
3. A few
hours later, the price moves to 1.4550 and you decide to close your trade.
4. The new
quote for USD/CHF is 1.4550 / 1.4555. Since you're closing your trade and you
initially bought to enter the trade, you now sell in order to close the trade
so you must take the "bid" price of 1.4550. The price traders are
prepared to buy at.
5. The
difference between 1.4530 and 1.4550 is .0020 or 20 pips.
6. Using our
formula from before, we now have (.0001/1.4550) x 100,000 = $6.87 per pip x 20
pips = $137.40
Remember, when you enter or exit a trade, you are subject to the
spread in the bid/offer quote. When you
buy a currency, you will use the offer or ask price and when you sell, you will use the bid price.
Next up,
we'll give you a roundup of the freshest forex lingos you've learned!
