In the past, spot Forex was only traded in specific quantities called “lots”. The standard lot size is 100,000 units. There are also mini, micro and nano lot sizes equivalent to 10,000, 1,000 and 100 units respectively.
As you certainly know, the change in value from one currency to another is measured in Pips, which are very small percentages of the value of a currency unit. To take advantage of these value changes, you must trade large quantities of a particular currency in order to recognize a significant gain or loss.
Suppose you use a batch with a standard size of 100,000 units. We will therefore recalculate some examples to see how the Pip value is affected.
USD/JPY at an exchange rate of 119.80 (0.01/119.80) x 100,000 = 8.34 USD per pip
USD/CHF at an exchange rate of 1.4555 (0.0001/1.4555) x 100 000 = 6.87 USD per pip
The formula is slightly different in the case where the U.S. dollar is not the base currency.
EUR/USD at an exchange rate of 1.1930 (0.0001 / 1.1930) X 100 000 = 8.38 x 1.1930 = 9.99734 USD rounded to 10 USD per pip
GBP/USD at an exchange rate of 1.8040 (0.0001 / 1.8040) x 100 000 = 5.54 x 1.8040 = 9.99416 rounded to 10 USD per pip.
It is possible that your broker will propose different Pip calculation conventions depending on the batch size but whatever its method, it will be able to tell you what is the value of the Pip inherent to the currency you are trading at any time. The value of the Pip changes according to the market and depends on the currency in which you are positioned.
What is leverage?
You’re certainly wondering how a small investor like you can negotiate such large sums. Imagine your broker as a bank that would advance you $100,000 to buy currency. All the banks require from you is a $1,000 advance from you representing a deposit he will manage for you without keeping it. Too good to be true? This is how the leverage effect on Forex trading works.
The amount of leverage used depends on your broker and what you are willing to risk.
Generally, the dealer will require a deposit on the account acting as “account margin” or “initial margin”. Once the money is deposited, you can start trading. The broker will also tell you how many lots you can trade on a particular position.
For example, if the authorized leverage is 100/1 (or 1% required on the position), and you want to trade a $100,000 position with only a $5,000 account, the broker would secure $1,000 in advance or “margin” and let you “borrow” the rest. Of course, any loss or gain will be deducted from or added to the principal on your account.
The maximum margin of safety required for each lot varies among brokers. In our example above, the broker required a 1% margin. This means that for every $100,000 traded, the broker requires $1,000 in position deposits.
How can I calculate profit and loss?
Now that you know how to calculate the Pip value and leverage, let’s look at profit and loss calculations.
Let’s buy US dollars and sell Swiss Francs.
The quotation price is 1.4525/1.4530. Because you buy US dollars, you will work on the bid price of 1.4530 or the rate at which traders are preparing to sell.
You buy a standard lot (100 000 units) at 1.4530.
A few hours later, prices reach 1.4550 and you decide to close your trade.
The new quotation for USD/CHF is 1.4550/1.4555. Since you are closing your position and have bought to enter the market, you are now selling to enter the price of 1.4550, the price at which traders are preparing to sell.
The difference between 1.4530 and 1.4550 is 0.0020 or 20 pips.
Using our previous formula, we now have (0.0001/1.4550) x 100,000 = 6.87 USD per pip x 20 pips =137.40 USD.
Remember that when you enter or exit a trade, you are subject to the bid/ask spread. When you buy a currency, you use the bid price and you use the ask price when you sell.
In the next article, we will offer you a lexicon of Forex jargon that you have learned!