Making Money With Forex
What are Pips, Lots, Leverage and Margin?
So How Do You Actually Make Money in Forex?
You make money in Forex by profiting on the fluctuation of the exchange rate between two currencies. This is why you are always trading currency pairs and not just a single currency. The first thing that you need to understand is that you are always buying one currency and selling the other in order to trade their exchange rate. Let’s take a look at the GBP/USD as a symbol name to explain further.
if you buy GBP/USD = you are buying the GBP and selling the USD at the same time. (a.k.a going Long)
if you sell GBP/USD = you are selling the GBP and buying the USD at the same time. (a.k.a going Short)
The first currency displayed is known as the base currency and the second is the quote currency.
GBP/USD = GBP is the base currency
GBP/USD = USD is the quote currency
So What is a Pip?
Many years ago a pip was simply the last decimal place that you could see on your chart. As time has progressed most brokers now display everything an extra decimal point further which is essentially 1/10th of a pip. For many currencies this means that we have now gone to a 5th decimal place but for others it means we have gone to a 3rd decimal place. Sounds a little confusing but it isn’t that hard to get your head around. All you really need to know is that on any currency pair you see displayed to the 5th decimal place it is the 4th decimal place where you start to measure pips. On any currency pair that you see displayed to the 3rd decimal place it is the 2nd decimal place that you start to measure pips. Here are some examples to help make this clear.
If the GBP/USD changes from 1.65000 to 1.65010 = the exchange rate has moved by 1 pip.
If the EUR/JPY changes from 144.000 to 144.010 = the exchange rate has moved by 1 pip.
If the GBP/USD changes from 1.65000 to 1.66000 = the exchange rate has moved by 100 pips.
If the EUR/JPY changes from 144.000 to 145.000 = the exchange rate has moved by 100 pips.
So How is a Pip Valued?
There is a simple formula that you can follow to determine the value of a pip in either the base or quote currency of the pair you are trading.
(1 pip ÷ exchange rate) x trade size = value per pip in base currency
value per pip in base currency x exchange rate = pip value in quote currency
Let’s take a look at the GBP/USD and determine the value of 1 pip if the exchange rate is 1.65000 and we trade £10,000.
(0.0001 ÷ 1.65000) x 10,000 = £0.60606060
£0.60606060 x 1.65000 = $1
Let’s take a look at the EURJPY and determine the value of 1 pip if the exchange rate is 145.000 and we trade €10,000.
(0.01 ÷ 145.000) x 10,000 = €0.68965517
€0.68965517 x 1.65000 = ¥100
Of course you can multiply the value per pip in base currency by the exchange rate of any currency you like if you trading account itself is in a different currency. If we wanted to know our EURJPY pip value in USD than we can simply do this: €0.68965517 x current EURUSD rate.
So What is Spread? or the Bid/Ask?
Spread is the difference in Pips that you will pay when you Enter an order, or put another way, the difference between the buy (ask) price and sell (bid) price. When trading the major currency pairs most brokers will off a Spread of 1-3 Pips. This means that if the exchange rate on the GBP/USD reads 1.6500 and you wanted to buy, your Entry Price will be between 1.6501-1.6503 depending on what the spread was at the second you entered the trade. Spreads will vary from broker to broker and they will also vary within each broker, especially when moving between low and high volume trading times. You must take care around major news events as the spreads are know to spike in size.
So What is Leverage?
In the examples above to calculate the value of a pip £10,000 and €10,000 were used as our trade size. You are probably thinking that you don’t really want to risk that much to start and I don’t blame you. Fortunately trading forex opens the doors for you to trade with high leverage and you can actually buy or sell £10,000 by using a much smaller amount. If you are a US Resident you are limited to 50:1 leverage on your account but if you live anywhere else there are brokers out there offering up to 888:1! Let’s take a quick look at both extremes.
If you have a £2,000 account with 50:1 leverage.
You can buy or sell £10,000 worth for just £200.
If you have a £2,000 account with 888:1 leverage.
You can buy or sell £10,000 worth for just £11.26.
The latter example is very extreme and usually 500:1 seems to be the top end. You will be able to select your leverage when you create your account with them, you could chose 100:1 or 200:1 for example. Either way you can buy or sell a whole lot more than you actually have and that is why you are just a speculator.
So What is a Margin Call?
High leverage can be a big plus when used intelligently but before you getting too excited just remember one thing. Even though you can enter a large position using a very small portion of your account the value of each pip still be in relation to the size of the position. This is where lack of experience results in Margin Calls but they are easy to avoid if you have done your reading first. Let’s take a look at an extreme example so you can understand the math.
If you have a £2,000 account with 500:1 leverage you can buy or sell £500,000 on the GBPUSD using just £1000 of your account. If we stick with 1.65000 as the current exchange rate; the problem is that every pip the market moves against you it will use £30.30303030 of your remaining £1000. That means that with a 33 pip against you it’s game over. A 33 pip move against you is not uncommon and it can be very fast also.
That was an extreme example by the point is clear; high leverage can be used to barely use any of your account for being in a position but you need to be smart about your lot size. You should never risk your whole account on just 1 trade.
So What are Lots?
The final part for you to understand are these ‘lots’ that you keep hearing about and the best way to start off this explanation is with a table. The lot size that you trade will determine your actual trade size. In the examples above we have been using what are know as mini lots (10,000 of the base currency).
Try not to think about the money when you are trading, just make sure your math is correct and that you are trading the right lot sizes for your account regardless of your leverage.
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