Forex is often transacted in lots, which are effectively the number of currency units you will buy or sell. A “lot” is a unit of measurement for the quantity of a transaction. When you submit orders on your trading platform, they are put in lot sizes. It’s similar to an egg carton (or egg box in British English). When you buy eggs, you normally buy a carton (or box) (or box). One carton has 12 eggs.
The typical lot size is 100,000 units of cash, but there are now mini, micro, and nano lot sizes of 10,000, 1,000, and 100 units.
Some brokers display the quantity in “lots,” while others display the actual currency units. As you may know, the change in the value of one currency compared to another is measured in “pips,” which is a very small proportion of the value of a unit of money. To profit from this minute shift in value, you must trade big amounts of a specific currency to notice any significant profit or loss.
Assume we’ll be using a standard lot size of 100,000 units. We’ll now recalculate some samples to see how the pip value changes:
1. USD/JPY at an exchange rate of 119.80: (.01 / 119.80) x 100,000 = $8.34 per pip
2. USD/CHF at an exchange rate of 1.4555: (.0001 / 1.4555) x 100,000 = $6.87 per pip
The calculation is slightly different when the US dollar is not listed first.
EUR/USD @ 1.1930: (.0001 / 1.19 30) X 100,000 = 8.38 x 1.1930 = $9.99734, rounded up to $10 per pip
GBP/USD at 1.8040: (.0001 / 1.8040) x 100,000 = 5.54 x 1.8040 = 9.99416 rounded up equals $10 per pip.
The following are samples of pip values for EUR/USD and USD/JPY based on lot size.
Your broker may use a different method for determining pip values relative to lot size, but they will be able to tell you what the pip value is for the currency you are trading at the time.
In other words, they do all of the math for you!
Depending on the currency you are trading, the pip value will change as the market changes.
What is Leverage?
You may be asking how a little investor such as yourself can trade such enormous sums of money. Consider your broker to be a bank that lends you $100,000 to buy currencies. All the bank requires is a $1,000 good faith deposit, which it will hold for you but not necessarily keep.
Is it too perfect to be true? This is how leveraged forex trading works.
The amount of leverage you utilize will be determined by your broker and your level of comfort. A deposit, commonly known as “margin,” is usually required by the broker.
You will be able to trade once you have deposited your funds. The margin required per position (lot) traded will also be specified by the broker.
For example, if the permissible leverage is 100:1 (or 1% of the position necessary) and you wish to trade a $100,000 position but only have $5,000 in your account.
No issue, your broker will set aside $1,000 as a deposit and let you to “borrow” the remainder. Of course, any losses or gains will be withdrawn or added to your account’s remaining cash amount.
The minimum security (margin) for each lot will differ amongst brokers.
In the preceding case, the broker demanded a 1% margin. This means that for every $100,000 exchanged, the broker will require $1,000 as a position deposit. Assume you want to purchase one ordinary lot (100,000) of USD/JPY. If your account is permitted 100:1 leverage, you must put up $1,000 in margin. The $1,000 is a deposit, not a cost. When you close your trade, you get it back.
The broker requires the deposit since there is a danger of losing money on the position while the deal is open! If the USD/JPY falls and your trading losses reduce your account equity to less than $1,000, the broker’s algorithm will immediately close out your transaction to prevent future losses.
This is a safeguard to keep your account balance from becoming negative.
How do you Calculate Profit and Loss?
Now that you understand how to determine pip value and leverage, let’s look at how to compute profit or loss.
Let’s exchange dollars for Swiss francs:
1. The rate you’ve been given is 1.4525 / 1.4530. Because you are purchasing US dollars, you will be using the “ASK” price of 1.4530, which is the rate at which traders are willing to sell.
2. So you pay 1.4530 for a typical lot (100,000 units).
3. After a few hours, the price has moved to 1.4550, and you decide to exit your deal.
4. The new USD/CHF quote is 1.4550 / 1.4555. Because you first bought to begin the deal, you must now sell to close the trade, hence you must accept the “BID” price of 1.4550. The price at which dealers are willing to buy.
5. The difference between 1.4530 and 1.4550 is.0020, or 20 basis points.
6. We now obtain (.0001/1.4550) times 100,000 = $6.87 per pip x 20 pips = $137.40 using our previous approach.
Remember that whether you enter or quit a transaction, you are susceptible to the bid/ask spread. When purchasing a currency, the offer or ASK price will be used. You will utilize the BID price when selling.
Next Lesson: What is a Spread in Forex Trading?