Trading Lots, Leverage, and Profit and Loss
Before now, spot forex was traded in specific amounts called lots. 100,000 is a standard size for a lot. In line with this, mini, micro, and nano lot sizes are considered to be 10,000, 1,000, and 100 units respectively.
Pips is a term used to measure currencies in forex trading. It is also considered to be the smallest increment of that currency in trading forex. To be successful in taking these tiny increments, you as a market player needs to trade huge amounts of a particular currency in order to see any significant profit or loss.
Let’s make this as an example. We will be using a standard lot size which is 100, 000 unit. We will now recompute some examples to see its effects on pip value when trading.
- USD/JPY at an exchange rate of 119.80 (.01 / 119.80) x 100,000 = $8.34 per pip
- 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.
- 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
- 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.
Brokers are different so as their ways of computing and recomputing pip value in relation to the lot size in trading. However, it needs to be made clear that whichever way they do it, they’ll be able to present you what the pip value is for the currency you are trading is a that specific time. Remember that when the market moves, pip value also moves depending on the current currency you are trading.
What is Leverage
I know you are wondering how come a small investor like yourself can trade such huge amounts of money. Well, think of your broker who will serve as a transition and will front you $100,000 to buy currencies. When it comes to banks, a bank will ask you to give it $1,000 as a good faith deposit, which it will hold for you but necessarily keep. Doe it sound so good to be true? Well, that’s how trading forex using leverage works.
In line with this, the amount of leverage you will use in trading will depend on your broker and what you feel comfortable with.
Basically, a trade deposit is required by many brokers when trading. This trade deposit is known as ” account margin” or “initial margin”. You can start trading once you have deposited your money. Along with this, brokers will also specify how much position (lot) is required when trading.
Let say for example, if 100:1 (or 1% of position required) is the the allowed leverage is, and you wanted a position worth $100,000 to trade , but you only have $5,000 in your account. No worries! Your broker would set aside $1,000 as down payment, or the “margin,” and let you “borrow” the rest. However, you need to remember that any losses or gains will be deducted or added to the remaining cash balance in your account.
Also, you have to bear in your mind that the minimum security (margin) for each lot differs from one broker to broker. If you’ll look at the example above, a one percent margin was required by the broker. This means that for every $100,000 traded, the deposit on the position that the broker wants is $1,000.
How do I calculate profit and loss when trading forex?
After learning how to calculate leverage and pip value, it is now time to learn and understand how you compute your profit or loss.
In this example, we are going to buy US dollars and sell Swiss Francs. Let the trading begin!
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”or sell price of 1.4530.
2. So you buy 1 standard lot, that is 100,000 units at 1.4530.
3. After a few hours, 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” or buy 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
One thing you need to remember when entering or exiting in trading forex, you are subject to the spread in the quote of bid or offer. Therefore, if you plan to buy a currency, you will use the offer or ask price. On the other hand, when you sell, you will use the price of the bid.
In our next lesson, you will learn some of the freshest and famous forex lingos in trading.
Proceed to the next lesson: Freshest Forex Lingo in Trading Forex
Back to the Previous lesson: Pips & Pippetes
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