Forex trading can seem complex at first, but understanding some core concepts makes it much easier to grasp. Three fundamental ideas every beginner must master are pips, lots, and leverage. These concepts work together to determine how you trade and how much potential profit or loss you could experience. Let’s break down each one in simple terms.
What are Pips?
In forex trading, a “pip” (percentage in point) is the smallest unit of price change for a currency pair. Think of it like the cent in a dollar or the pence in a pound. It measures how much the relative value of two currencies fluctuates.
Most currency pairs are quoted to four decimal places (e.g., EUR/USD = 1.1055). A pip change is the fourth decimal point. So, if EUR/USD moves from 1.1055 to 1.1056, that’s a one-pip increase. Some currency pairs, especially those involving the Japanese yen, are only quoted to two decimal places; there, the second decimal is the pip. For example, if the USD/JPY moves from 145.25 to 145.26, that is a one-pip increase.
Why does this matter? Because traders use pips to calculate their profit or loss. Each pip movement changes your profit or loss position, depending upon whether your prediction of the price direction was correct or not.
Example: Let’s say you bought the EUR/USD at 1.1055 and sold it later at 1.1060. The difference of 0.0005 means the price went up by 5 pips. Your profit (ignoring other factors like commissions) would be based on the value associated with those five pips.
Understanding Lots
A “lot” is simply a standardized unit of transaction size used in forex trading. Instead of trading single units of currency, you trade them in predetermined batches called lots. Trading in lots is a more practical way of buying/selling currency pairs. Trading using lots is how to make the most of small price changes.
There are a few common lot sizes:
- Standard Lot: 100,000 units of the base currency. For example, if you trade one standard lot of EUR/USD, you’re trading 100,000 euros.
- Mini Lot: 10,000 units of the base currency, which is a tenth of a standard lot.
- Micro Lot: 1,000 units of the base currency, a tenth of a mini lot and a hundredth of a standard lot.
Different brokers may offer different sizes including nano lots (100 unit lots). The lot size you choose directly impacts your risk and potential profit. Smaller lot sizes mean less capital at risk with smaller profit amounts compared to bigger lot sizes with larger potential risk and profit/loss.
Example: Let’s say you trade one standard lot of EUR/USD. Every pip move in EUR/USD will result in around $10 of your profit or loss in the trade. If you trade one mini load, the profit/loss would be around $1. Using a micro lot, the profit/loss for that pip move would be about $0.1.
The Magic (and Risk) of Leverage
Leverage is a tool offered by forex brokers that allows traders to control a much larger amount of money than they actually have in their account. It’s like borrowing money to amplify your potential return. Leverage is expressed as a ratio, such as 50:1 or 100:1. A ratio of 100:1 means that with every $1 of your own capital, you can control $100 in the market.
Example: If you have $1,000 in your account and your broker offers 100:1 leverage, you can control up to $100,000 in trade positions ($1000 * 100 = $100,000). You can imagine how using leverage significantly increases your profit (or loss) potential.
However, leverage is a double-edged sword. While it multiplies potential profits, it also multiplies potential losses. A small adverse movement in the market could quickly erase your capital if over-leveraged.
Important Considerations:
- Risk Management: Always use leverage responsibly. Never risk more than you can afford to lose. Implement risk management strategies such as using stop-loss orders to limit potential losses.
- Margin: When you use leverage, your broker will require you to keep a small percentage of the capital you are controlling in your account. This deposit is known as the margin. If losses become substantial, your broker may close out your profitable trades, also known as a margin call.
- Volatility: Higher volatility markets require lower leverage. The volatility of a currency pair will depend on what is happening politically and economically in the region where the particular currency is located, so be aware of these conditions.
How Pips, Lots, and Leverage Work Together
Let’s see how the concepts of pips, lots and leverage work together. Your potential profit or loss depends on all three concepts. First, you need to know what is the pip value based on whatever currency you trade. Then, you choose your lot size depending on the amount of risk you are happy to take. Using leverage magnifies potential profits (and potential losses). Let us put this into a practical example.
Assume you trade the EUR/USD and anticipate correctly it will go up. You purchase one mini lot position of EUR/USD, meaning you are buying 10,000 Euros. You select a leverage of 50:1. This means that you only need to have a small percentage of what is equivalent to 10,000 Euros. This amount based on your broker’s margins will sit in your account as “margin.” If the overall exchange rate of the EUR/USD goes up by 10 pips, you would have earned approximately $10 in profit (because each pip is worth approximately $1 when trading a mini lot position in EUR/USD.
However, if you predicted wrong and the price fell by 10 pips, you would have made a loss of approximately $10.
Now, let’s see what happens if you had placed one standard lot (100,000 euros) for the same pip movement. If it rose by 10 pips, you could have made a profit of around $100 and if the exchange rate fell by 10 pips, you would have made a loss of approximately $100.
Conclusion
Understanding pips, lots, and leverage is essential for any aspiring forex trader. Pips measure price movements, lots determine the size of your trade, and leverage magnifies your potential gains and losses. Used responsibly, these concepts can be powerful tools for potentially profitable trading. However, every trader must learn how to control risk and use leverage carefully to avoid large capital losses.
Before engaging in any forex trading activity it is important to seek professional financial advice as it is a risky endeavor. This is not financial advice. Learn everything you can before commencing trading.
Frequently Asked Questions
References
- Investopedia: Forex Trading
- Babypips: School of Pipsology
- DailyFX: Educational Resources
Are you ready to trade? Explore our Strategies here and start trading with us!