What is Most Important I Should Know

Before you actually trade FOREX, it is very important that you understand all the terms used in FOREX Market.

Now, the most important thing you need to know would be how to calculate your Profit/Loss, right? For this, you have to understand Pips, Lots, Margin and Leverage.

Pip

A "pip" is the smallest price increment in any currency pair (e.g. the smallest price change/move). In EURUSD, a movement from .8941 to .8942 is one pip, so a pip is .0001. In USDJPY, a movement from 130.45 to 130.46 is one pip, so a pip is .01. How much in dollars is this movement worth, for example, per 10,000 Euros in EUR/USD? How much is one pip worth per 10,000 Dollars in USD/JPY? We will refer to the size, in this case 10,000 units of the base currency, as the "Notional Amount". The formula for calculating a pip value is therefore:

(one pip, with proper decimal placement/currency exchange rate) x (Notional Amount) = pip value

Using USD/JPY as an example: (.01/130.46) x $10,000 = $0.77 or 77 cents per pip.

Using EUR/USD as an example: (.0001/.8942) x EUR10,000 = EUR 1.1183.

But we want the pip value in USD, so we then must multiply EUR 1.1183 x (EURUSD exchange rate): EUR 1.1183 x .8942 = $1.00.

This is in fact a phenomenon you will see with any currency in which the currency is quoted first (such as EUR/USD, GBP/USP, or AUD/USD): the pip value is always $1.00 per 10,000 currency units. This is why pip (or "tick") values in currency futures, where the currency is quoted first, are always fixed.

Approximate pip values for the major currencies are as follows, per 10,000 units of the base currency:

EUR/USD:
1 pip = $1.00; change from 1.5000 to 1.5001 is worth $1.00 per 10,000 Euros.

USD/JPY:
1 pip = $.77; change from 130.45 to 130.46 is worth $0.77 per $10,000.

GBP/USD:
1 pip = $1.00; change from 1.4765 to 1.4766 is worth $1.00 per 10,000 Pounds.

USD/CHF:
1 pip = $.59; change from 1.6855 to 1.6866 is worth $0.59 per $10,000.

Lots

You cannot simply buy currency in any value you like. For instance, USD/CAD 1.4890, when you want to buy USD you cannot simply buy 1USD or 10USD or 15USD as you wish.

Instead the buying and selling are done in lots (transaction size). Standard lot size is $100,000.00 So, when you buy, you have to buy either one lot or two lots, or a hundred lots. One lots means you are buying $100,000, buying two lots would mean buying $200,000.

For example, with USD/CHF the base currency is US dollar, therefore if to trade 1 standard lot of USD/CHF it would be worth $100 000.

Another example: GBP/USD, here the base currency is British Pound (GBP), a standard lot for GBP/USD pair will be worth £100 000.

There are three types of lots (by size):

• Standard lots = 100 000 units/quantities.
• Mini lots = 10 000 units/quantities.
• Micro lots = 1000 units/quantities.

Units/Quantities refer to the base currency being traded.

Mini and micro lots are offered to traders who open mini accounts (on average from $200 to $1000). Standard lot sizes can be traded with larger accounts only (the requirements for a size of standard account vary from broker to broker).

The smaller the lots size traded, the lower will be profits, but also the lower will be losses.

• With every Standard lot (100 000 units) a trader can get a profit / loss of $10 per pip.
• With every Mini lot (10 000 units) a trader can get a profit / loss of $1 per pip.
• With each Mini lot (1000 units) a trader can get a profit / loss of $ 0.10 per pip.

Remember that the forex market has no central marketplace. The forex dealer determines the execution price, so you are relying on the dealer’s integrity for a fair price.

Margin

Forex and commodity trading is always conducted on "margin".  This means that a cash deposit, usually much smaller than the underlying value of the currency or commodity contract, is required in order to trade.

For example, a broker might require only $1,000 in the trader's account in order to trade a $100,000 currency position.  The $1,000 is referred to as "margin".  This amount is essentially collateral to cover any losses that you might incur.  Since nothing is actually being purchased or sold for delivery, the only requirement, and indeed the only real purpose for having funds in your account, is for sufficient margin.

Margin should reflect some rational assessment of potential risk in a position.  For example, if a currency is very volatile, a higher margin requirement would normally be justified.  One common rule of thumb is a worst-case one day move in the market.  So if a $100,000 currency position is unlikely to move by more than 1% (or $1,000) in a 24 hour period, a $1,000 margin requirement is probably reasonable.  If, however, the currency or commodity in question is highly volatile and is likely to move by, say, $3,000 or more (or 3%, as is often the case with certain NASDAQ stocks and some commodities) it would put the broker at increased credit risk to require only a $1,000 margin deposit.

Note that margin available in your trading account is based on account equity, not account balance.  The equity is the most accurate measure of the value of your account, as it takes into account unrealized gains or losses.

Leverage

Leverage by definition is: "The use of a small amount of cash to control a large amount of commodity", in this case : currency.

Simply put, your forex broker will lend you a large amount of money to trade provided you have a specified minimum amount of balance in your trading account.

For example if your broker gives you a 100:1 leverage, you can control a lot the size of $100,000 for every $1,000 you have. If you have $3,000 you can trade $300,000 dollars.

Why is Leverage important?

Remember Pip Value? Surely you have noticed that the increment size of any currency is as small as 0.0001. So, for you to receive any significant profit, you have to trade with large amount.

For example:

• Your broker allows you a leverage of 100:1 which means you can trade a $100,000 sized lot with $1,000
   
• You predicted that GBP rate will rise against US Dollars. So, you opened a lot, buy buying GBP at 1.9869.
   
• After a while, your prediction comes true. The GBP rises against USD. So you close your position at 1.9919.
   
• You earn 50 pips. Convert to dollar amount, you get $500

Your initial capital was $1,000 right? So you make 50% profit.

You will not earn that much without leverage.

But,

Always remember that Leverage is a two edge sword.

Just imagine you prediction go wrong and you are down by 50 pips instead. That will give you a 50% loss.

So, always trade cautiously. And use leverage wisely.