Before you start your first trade, there are a couple of terms and concepts that you must first understand.
Understanding different concepts such as lots, margin, and leverage will come in handy when you are trying to determine possible losses and gains.
It is important that you first know all of the factors that are involved in a single trade so that you can accurately assess the amount of money and risk you can take.
Margin and Leverage
For someone who wants to become a professional trader, it’s a must first to grasp the concept of margin and leverage.
Also, it’s important to find a comfortable value in terms of your account’s margin policy and leverage amount.
Leverage basically means that you can control a significantly large amount of money to trade using very little of your own by borrowing money from the retail broker.
The loan will give you a larger position than what you would otherwise be able to afford. Leverage is often expressed as a ratio.
For example, a ratio of 100:1. In this example, if you deposit US$1,000 into your account, you would be able to place investments in the Forex market of up to US$100,000.
This can, of course, be both an advantage and a disadvantage for you.
Most traders who don’t know how to handle their leverage will mostly blow their account in just a couple of trades.
Let’s just say you managed to increase your account balance from US$100,000 to US$101,000 in the span of a few trades using a 100:1 leverage from a certain broker.
When you cash out, you have basically made a 100 percent profit from your initial investment of just US$1,000.
If you had to make the same investment from your own pocket, the return would have been only 1 percent of your initial investment.
With leverage, you have exponentially increased your profits.
Now, reverse the scenario and let’s pretend that you lost US$1,000 after a couple of trades.
In this case, you will lose 100 percent of your investment and the broker will immediately take back the rest of the money they lent you.
Leverage is sometimes referred to by veteran traders as a double-edged sword. You can either make big profits from it or instantly blow your entire bankroll if you don’t know what you are doing.
In the United States, leverage is only limited to 50:1 for most major currency trades.
This was initiated during the revision of the National Futures Association (NFA) rules.
However, some brokers outside the United States can offer leverages of up to 100:1 or even greater. While these might be tempting to some traders who want to get rich quick, those who are still starting out may want to try out accounts with lower ratios.
The most common leverage amounts offered by retail brokers are 20:1, 50:1, 100:1, and the highest possible 400:1.
When a broker gives you leverage, they will want some form of collateral from you in case you make some bad bets.
In the prior example, your initial deposit of US$1,000 is used as your market for you to loan US$100,000 from the broker. A margin is an amount needed to open a larger position with your broker.
Your margin deposit is actually pooled together with the other trader’s deposits on the platform to be used to place trades on the interbank network.
Margins are expressed as percentages, based on the full amount of your trading position.
In the example above, your US$1,000 deposit is the required 1 percent margin to get a US$100,000 position. Margins can also be used to calculate your maximum leverage that can be used on your account.
If a broker required a 2 percent margin, then you will have a maximum of a 50:1 leverage.
Different brokers will actually have different systems put in place to protect their investments with you.
These are often declared under a broker’s margin policy. There are a couple of terms that you need to know, which will be mentioned under these policies.
Margin required is the amount your broker will need to give you your leveraged position.
An account margin is basically just your current bankroll minus any open trades and interests.
Your used margin is the amount of money that has been locked up by the broker to keep your current trades open.
A usable margin is an amount of money in your account you can still use to make new trades.
All of the mentioned amounts aren’t technically yours, at least not the leveraged totals.
You can only get access to your money when you close all your current trades and positions or until you get a margin call.
It is imperative that you go over your broker’s margin policy before you make your deposit.
The important thing to look out for includes knowing how your broker calculates interest; this must be done beforehand.
This includes the amount of interest they charge for intraday positions and overnight positions.
Different brokers tend to charge different interest rates for long positions.
Brokers usually manage these through a system called rollover.
If you end up with a positive interest rate, which happens when a trade is up during a long call, you will receive a rollover credit that is instantly reflected in your account.
On the other hand, if you end up with a short interest rate on a losing trade, you will get a rollover debt.
You also need to know how and when they will initiate a margin call and if the broker will warn you before closing your positions if you run out of funds.
Some brokers do this automatically, while some will give you the opportunity to add funds to your account.
Pips and Lots
In Forex trading, you will hear a lot of people talk about “pips.”
The terminology is thrown around to indicate profits and losses.
It is also used to indicate market movements and changes.
Knowing what a pip is and how it is calculated will be required knowledge for anybody interested in trading on the Forex market.
To be said simply, a pip is a unit of measurement used to indicate the change in value between currencies.
The term also stands for “point of percentage,” and is considered to be the smallest measure of change between currency pairs.
Each currency pair will have different measurement value, calculated in decimal places. Some currencies will have values within two decimal places, while the US dollar paired with other currencies, for example, will be quoted with four decimal places.
A pair with a US dollar currency will be quoted as 0.0001, for example. If the value increases to 0.0002, then it has increased by 1 pip.
The standard sizes of different currencies were put in place to make sure that investors don’t incur large losses.
A one-pip change would cause a lot of volatility in the market.
As an example, USD/EUR with a quote of 0.8000 would mean that you can buy 0.8 euros with US$1.
If the quote increased by 10 pips, or 0.8010, the value of the US dollar has now increased as you can now buy more euros with the same US$1.
The value of a single pip movement isn’t static as it will depend on the number of lots that were initially chosen before the trade was made.
In the past, before the advent of retail Forex brokers, spot Forex trading was traded in a specific amount.
The standard amount was called a lot or a standard lot in today’s terminology.
The standard lot represents 100,000 units of a particular currency.
Nowadays, lot sizes come in different denominations. 10,000 units of currency are called mini lots, 1,000 units are called micro-lots, and 100 units are called micro lots.
The system was put in place to allow traders to place in precise amounts of money for each trade, with wins and losses dependent on the number of lots placed and the number of pip movements.
To make a lot of money in very small pip movements, traders can place their trades with large lots.
For example, if someone were to place a trade using a standard lot for USD/JPY with a quote of 120.10, each pip movement would mean a gain or loss of US$8.33.
The formula to come up with this value is basically to divide one pip, in this case, 0.01, by quote 120.10.
The result is then multiplied by the lot size, which is, in this case, 100,000 lots.
The formula looks like this – (0.01 / 120.10) x 100,000).
If the US dollar is the quote currency and not the base currency, you only need to multiply the result of the previous formula with the quote again.
Let’s just say that the JPY/USD is quoted as 0.0091, each pip movement using a standard lot would be US$10 per pip.
The formula would look like this – ((0.0001 / 0.0091) x 100,000 = result x 0.0091).
By adjusting the lot sizes within the same formula, it would be effortless to determine the value of a single pip movement for different currencies.
Again, the amount of math required to compute these values might turn off some traders, but this is something that must be learned to properly determine the amount of possible gain and loss for each trade.
Some brokers do have these calculated automatically on their platforms, but for those that don’t, you may have to do the math yourself.
In simple terms, a spread is the difference between the asking price and the bidding price of a trade.
This is basically how Forex brokers make their money.
This is mainly the reason why they can give you access to their platforms and software for free to encourage you to trade.
Some are willing to provide you with bonus deposits just so that you can make more trades.
The spread is the broker’s way of charging you for every trade.
This is also the reason why you need to fully understand the concept so that you know what you are getting yourself into.
As previously mentioned, every currency pair is quoted with two sets of numbers.
One is for the asking price, and the other is for the bidding price.
Traders who are betting on the trend to go up will enter the market at the asking price, usually indicated under “buy.”
Traders who are shorting or selling, betting that the trend will go down, will enter the market at the bid price, usually indicated under “sell.”
As an example, if you want to buy a certain amount of currency and then sell it again immediately, you will lose money equal to that of the current spread.
An analogy would be, if you were to buy a car from a dealer, drive it out of the dealership, turn around and then sell it back to the dealer, the amount they would pay for the same car would be much less.
The difference in the prices will be the dealership’s profit. While the depreciation values of cars are much larger, Forex spreads are often not that huge.
The value of the spread will also greatly depend on trade lot size and the amount of the trade itself.
These are the essential elements that any naive trader must learn, hence make sure to get a complete understanding!