Forex Lesson 1: The Bare Essentials
Forex trading is a type of currency trading based on the exchange rate between two currencies. In Forex the points are known as the pips and are worked out in different ways depending on the currencies being traded. The pip is always the last decimal place quoted, In most wholesale market currencies the pip is quoted four places to the right of the decimal point reflecting 1/10,000th of the value, 0.0001. In USD/JPY trades the pip is two places to the right of the decimal point, reflecting 1/100th of the value, 0.01
Currencies are always priced in pairs for example you could trade on USD/GBP, AUS/CAD, GBP/JPY, the possibilities are endless but there is one golden rule and that is there must always be two currencies to compare. With spot currency trading you are essentially buying one currency and selling another. The other important point to remember is that the actual exchange rate is not the price you trade on. The reason for this is that there is always a cost to set up a Forex trade. For example the GBP/EUR rate may be 1.40 but the buying price maybe 1.45, the five points or pips reflect the cost to the trader in setting up the trade but can easily be recouped by a successful trade.
What Spot Forex Investing Means:
When trading euro-dollar, your first currency makes up your base currency. For instance in the euro-dollar equation, when we say it is trading at 1.4520, it is the amount of dollars to the euro, or that one euro will buy you $1 and 45 cents (20 is four decimal points). Now if you think the present spot price of euro-dollar 1.4520 is going up to 1.50, what you would do is buy the amount of euros at 1.4520 which is equal to the amount of dollars of 145.2. If it goes up to 1.50, you would sell them and you make your profit of 5. In essence, you are betting on the price of one forex currency going up or down against the other.
Forex trading is based on a standard trading account size of $100,000. Smaller accounts can be used and are known as Forex minis with a value of $10,000, it is important to know the account size before placing a trade as this affects the value of a pip. The value of a mini account pip is 10% of the value of a $100,000 account.
Calculating Pip values
When working out the value of the pip you need to have the following information:
- The two currency types being traded.
- The pip type.
- The price of the trade based on the exchange rate.
- The lot or account size being traded on.
Sample Calculation for two pip place trades
| Currency pair: | USD/JPY |
| Pip size: | 0.01 |
| Price: | $155.00 |
| Account Size: | $100,000 |
The pip value can easily be worked out using the above information using the following calculation -:
Size of account, divided by price of trade, multiplied by pip size.
$100,000/$155.00 x 0.01 = $6.45.
The pip value therefore when trading USD/JPY is $6.45.
Other currency combinations with a pip size of two decimal places at 0.01 are -:
EUR/JPY
GBP/JPY
AUD/JPY
CHF/JPY
Essentially when trading JPY a two pip place calculation is used.
Sample Calculation for four pip place trades
| Currency pair: | USD/CAD |
| Pip size: | 0.0001 |
| Price: | $165.00 |
| Account Size: | $100,000 |
The same calculation can then be used replacing the two pip with the four pip figure.
$100,000/$1.65 x 0.0001 = $6.06.
Other currency trades with a four pip combination are:
EUR/CAD
GBP/CAD
GBP/CHF
AUD/CAD
Currency trades with a standard pip value.
Some currency trades have a standard pip value and don’t need to be calculated. The following trades have a standard pip value of $10:
EUR/USD
GBP/USD
AUD/USD
NZD/USD
Exceptions to the rule.
Two currency trade combinations that are exempt from the above calculations are the pairing of Euros with Great British Pounds and Euros with Australian Dollars.
Euro with GBP
When pairing these currencies in a trade it is important to know the price of GBP/USD. Using the price at which GBP/USD is trading, move the decimal point one place to the right. For example if the GBP/USD price is $1.5512 move the decimal place to the right one place to make it $15.51 the new figure is the pip value for trading EUR/GBP.
Euros with Australian Dollars
When pairing these currencies in a trade it is important to know the price of AUD/USD. Using the price at which AUD/USD is trading, move the decimal point one place to the right. For example if the AUD/USD price is $0.4876 move the decimal place to the right one place to make it $4.87 the new figure is the pip value for trading EUR/AUD.
Trading Forex Currencies
Trades can be based on $100,000 accounts or in $10,000 accounts. Trading is not based on individual units as this would make the profit margin too small and not worthwhile. $100,000 lots are standard Forex accounts to trade on with smaller accounts of $10,000 suitable for new traders or those with limited funds for trading.
When an account is opened a margin has to be in place, this margin determines the cost per trade. An account will be stopped if there is not enough money in it to cover the cost of the lots and the trade. Margins on a $100,000 lot can be agreed between the broker and the trader. Margins for $10,000 accounts are fixed at 0.005%.
$100,000 Lots and Margins
In an example case the margin agreed between broker and trader is 1% on a $100,000 lot. The trader has $15,000 in his account. The trader buys 5 lots of $100,000 based on the GBP/USD. Each lot costs him $1000, this is 1% of $100,000 and the agreed margin. The trader now has $10,000 in his account. The current trading price is 0.9831. If the pips fall by 70 points to 0.9761the trader will lose $3500. This is because the pip value for GBP/USD is $10. A 70 pip fall multiplied by $10 is $700, the trader has 5 lots open so the total loss is $700 multiplied 5 times to make a total loss of $3500. The trader now has $6500 remaining in his account. If the trade continued to fall by another 80 pips to 0.9681 the trader would lose a further $4000, leaving $2500. A further fall of 50 pips to 0.9631 means a final loss of $2500 and the account is closed with no margin possible.
$10,000 Lots and Margins
A trader must have 0.005% or $50 in his account for every lot traded. This means if you have 4 $10,000 lots open you must have at least $200 in your account. As the amount of the $10000 lot is 10% of a $100,000 everything else is reduced accordingly, so instead of GBP/USD being $10 per pip they will be $1 per pip in a $10,000 lot. Assuming the trader has an account with $400 his initial trades will cost him $200, at $50 per trade. If the price per trade is 0.8234 GBP/USD and it falls 50 pips to 0.8184 the trader will lose $200 ( $50 multiplied by four lots) and the account will be closed.
Spreads
The normal spreads on the most popular foreign exchange pairs are: EURUSD (1.0 to 3.0 pips), GBPUSD (1.5 to 4 pips), USDJPY: (1.2 to 3 pips). Some forex brokers offer very low (but variable) spreads, while others justify slightly higher, but fixed spreads. On a typical $10,000 trade size, 1 pip would be approximately $1.00 ($10 per pip on a $100,000 trade). The number of forex currency pairs offered is usually about 20 and as high as 170. A growing number of forex brokers worldwide are now also offering CFDs, as well as spot FX. CFDs are another type of over-the-counter (OTC) instruments, and derive their value from various markets, including: Forex, stock indices, and commodity futures.
Posted on April 25th, 2014 at 9:45 am
I know a lot of traders will find this helpful because no one seems to take lot size calculation seriously. Most traders just ‘guestimate’ what their lot sizing should be, but you really need to calculate the pip value of your trade to stop unnecessary losses.