Pips, Lots, and Leverage – oh my! Pips, Lots, and Leverage – oh my! No, this isn’t the set of a twisted, new production of the Wizard of Oz in which the Tin Man wears glasses and a pocket protector. These are some common words used in currency trading that you will need to add to your vocabulary in order to become a successful Forex investor.
You’ve probably come across these terms already during your investigation into currency trading. It is important to get a good grasp of these concepts before we go any further and explore the math associated with them. These concepts set the stage for knowledgeable Forex analysis and trading.
The Pip Exposed
As discussed in previous library articles, a pip is the smallest price change a given exchange rate can make. Most major currency pairs are priced to four decimal points, so the smallest change for most exchange rates is equal to a 1/100th of one percent increase.
Your profits and losses can be calculated in terms of how many pips you gained or loss. A pip is derived by comparing the starting rate to the ending rate. The difference between the two is how many pips you gained or lost.
For example, if the exchange rate for the USD/CHF was initially 1.2155 and rose to 1.2159 then it has moved 4 pips – which could be good or bad depending on whether you own Francs or Dollars.
Each currency has its own value which is usually expressed in relationship to another currency. As such, the value of one pip is different for each currency pair and depends on several factors – the main aspect being the exchange rate.
The value of a pip is derived by taking 1/10,000 of most currency pairs (this holds true for all exchange rates quoted with 4 decimal places – Japanese Yen or JPY is an exception and will be explained later) and dividing that by the exchange rate:
pip = 1/10,000 ÷ Exchange Rate
Let’s take a look at several of the main currencies to gain a better understanding of how a pip is calculated. We will express these examples where the USD is quoted first in order to express the value of the pip in terms of U.S. dollars.
Common Pip Calculations
Let’s assume that the exchange rate for the USD/EUR is 0.7272. Since the rate is quoted to the fourth decimal place then we can use our trusty formula of: pip = 1/10,000 ÷ Exchange Rate. So,
0.0001 ÷ 0.7272 = 0.00013751
Therefore, one pip for the USD/EUR currency is worth 0.000138.
Now, let’s assume the exchange rate for the USD/EUR is now 1.1234. Using our same logic and formula we can calculate the value of a pip:
0.0001 ÷ 1.1234 = 0.00008902
Doesn’t seem like much? Well, in the following discussions about lots and leverage you will see how pips can add up quickly.
There’s one little wrinkle in our pip calculations. What happens when the exchange rate of a currency pair is not expressed to four decimal places? While, this doesn’t happen too frequently there is one notable occurrence which is when the Japanese Yen or JPY is part of the currency pair.
Currency pairs involving the JPY are quoted with only two decimal places, so instead of using 1/10,000, we will now use 1/100 in our pip calculation which will look like this:
pip = 1/100 ÷ Exchange Rate
Let’s assume that the exchange rate for the USD/JPY is 123.51. To calculate the value of one pip for the USD/JPY pair with an exchange rate of 123.51 we would perform the following math:
0.01 ÷ 123.51 = 0.00008097
Therefore, one pip for the USD/JPY is worth 0.00008097.
A Lot Explained
Wheeewww. That seems like a whole bunch of work to calculate such small value. Don’t worry – pip values will almost always be calculated for you by most brokers and in most online trading platforms. But, a larger question is probably starting to form in your mind – How can I ever make any money in Forex trading with these worthless pips?!?
The answer can be explained by discussing the Forex term of a lot. Spot Forex is traded in lots or groups. The standard size for a lot is $100,000 and $10,000 is considered a mini lot size. Since currencies are measured in the tiny values of a pip, Forex trades are conducted with a large amount of money in order to gain a profit (or incur a loss).
Lots and Pips (Together at Last)
Let’s pretend that you just inherited $100,000 from your great aunt Matilda (may she rest in peace) and have decided to execute a few Forex trades. Since you have $100,000 you will be able to purchase a standard lot size from a broker.
After doing some research you decide to buy one standard lot of the USD/EUR at an exchange rate of 1.1234. Let’s find out how much one pip is now worth to you.
We do this by using our pip formula from before and multiplying it by your lot value, so it now looks like this:
pip = (1/10,000 ÷ Exchange Rate) x Lot Value
To apply this to our example, our formula looks like:
(0.0001 ÷ 1.1234) x $100,000 = $8.90 (rounded to two decimal places)
Therefore, the value of each one of the pips in your possession is worth $8.90 at the time of your Forex purchase. Ok, let’s now look at how this pip can earn you some money.
Profiting with Pips and Lots
Exchange rates are quoted in pairs as well know as the bid/ask spread. The first number in the spread is known as the bid price and the second is known as the ask price. So, for a bid/ask spread of 1.1229/34 the bid price is 1.1229 and the ask price is 1.1234.
For our example – remember dear Aunt Matilda? – let’s assume that when we bought our lot of USD/EUR the bid/ask spread was 1.1229/34 which is why we were able to buy our lot at the exchange rate of 1.1234 (the ask price).
A few hours later, you check the USD/EUR quote and discover that the bid/ask spread is now 1.1240/1.1247. This means the exchange rate at which you can sell your lot (the bid price) has increased to 1.1240. So, how many pips did you gain?
This can be calculated by subtracting the ask price you bought your lot of currency for from the bid price you can now sell your lot of currency for and then multiplying it by 10,000. Sounds confusing, but the following formula shows how simple it is using our example:
1.1240 – 1.1234 = 0.0006 then multiplied by 10,000 = 6 pips.
Now, in order to calculate your profit in actual dollars, take the number of pips you gained and multiply it by the value of your pips (which we calculated in the previous section). So, our actual profit from the money Aunt Matilda left us can be derived as follows:
(0.0001 ÷ 1.1234) x $100,000 = $8.90 x 6 pips = $53.40.
Alright, so if the standard lot size for currency trading is $100,000 then you’ve got to be a millionaire to trade Forex, right? Historically, this was the case. For a long time currency trading was consigned to huge corporations and the ultra-rich. However, regulatory modernization has allowed smaller traders to engage in Forex by allowing high-leverage trading.
Leverage is the ability to use borrowed funds based on the principal amount of money that you are able to invest. Many Forex brokers will offer leverage in ratios as high as 400:1.This means that if you have $250 to invest and a broker is willing to let you leverage that money at a 400:1 ratio then you are able to buy $100,000 ($250 x 400) or one standard lot.
How is this possible? Since Forex fluctuations are typically small (a one cent or 100 pips trade is considered a large move) – a broker is able to hold a small amount of collateral for a given position. Also, brokers will usually require a minimum balance for opening an account with the amount of leverage offered being tied to the size of the account opened.
Leverage allows Forex investors to gain a much higher return on their initial investment (it also allows for higher losses as well). Let’s use another example to demonstrate how leverage works.
Instead of inheriting $100,000 from Aunt Matilda, let’s now pretend that you take $1,000 which you earned cutting grass in your spare time and open a mini-account with a reputable Forex broker which offers 400:1 leverage.
Now, instead of using a full $100,000 to buy a standard lot we use $250 plus the leverage offered by the broker to buy a standard lot. Assume the same conditions exist as they did when we used Aunt Matilda’s money and we make a profit of $53.40 in a few hours. Our profit is still the same, but our rate of return is MUCH greater. Take a look:
Return on Investment (ROI) with Aunt Matilda’s Money: $53.40 ÷ $100,000 = 0.05%.
ROI with Leverage: $53.40 ÷ $250 = 21.36%
As you can see, using leverage GREATLY increase your return on investment. Would you rather earn 0.05% or 21.36% on your hard earned cash?
A natural question that emerges when discussing margin trading is what happens if I lose more money than I have in my account? Most Forex broker institute margin calls to ensure that you never lose more money then you have invested in your account.
Most margin calls are executed in real-time and on an automatic basis to close positions immediately before the market moves any further against a trade. Margin requirements – the amount of money put aside as collateral when opening a leverage position – vary from broker to broker and often depend on the size of your account.
Margin trading is can be dicey if you have not thoroughly researched your broker’s margin call policies and are not comfortable with risk involved. However, using margin as leverage will greatly increase your profits as a Forex trader.
You should now be able to understand now only what someone means when they mention a pip, lot, or leverage – but also how to apply it as a Forex trader. This comprehension will help you as we continue our discussion about currency trading.
Next: Types of Trade Orders