Pips and Lots
Currency traders value the worth of a currency pair, and trade sizes, in pips and lots. A pip is the smallest amount by which the value of a currency pair can change, although these days some brokers offer fractional pip quotes too. For example, when the value of the EUR/USD pair goes up by one tick (i.e. pip) the quote will move from 1.2345, to 1.2346, and the size of the movement is just one pip. An important guideline for the beginning trader is to measure success or loss in an account by pips instead of the actual dollar value. Example: a one pip gain in a $10 account, is equal, in terms of the trader’s skill, to a 1 pip gain in a $1,000 account, although the actual dollar amount is very different.
The smallest size in currency trading for professional traders is called a lot. For USD-based pairs, the lot size is 100,000. In other words, when you enter a trade with your margin account, the smallest amount that you can buy or sell is 100K, regardless of the size of your margin.
Margin and Leverage
Another important concept in currency trading is the twin phenomenon of margin and leverage. This is a concept that carries a high degree of risk, but since forex prices move very slowly (in terms of the actual change in value), the vast majority of traders leverage their accounts when engaging in short-term trading.
When you open a forex account, the broker will request that you deposit a small sum, known as margin, as insurance against the losses that your account may suffer. With this small sum, you’re able to control a much larger amount, enabling greater gains, but also greater losses than you would be able to achieve with your deposit. It’s easier to understand margin and leverage in the context of a borrowing process. The lots that you can trade are borrowed from your broker, who requires a margin deposit as an insurance against losses. The ratio between the funds borrowed by you, and the margin that you deposit as insurance is called leverage.
In order to understand how to manage your account you must gain a good understanding of leverage. Failure to pay proper attention to leverage and margin may result in a margin call and the broker may liquidate your position in order to ensure that your losses do not reach a level where your margin deposit is insufficient to cover them. Increasing leverage means increasing risk.
- You open a CFD trading account with $5,000 as margin, which is the collateral or equity in your trading account.
Your leverage is 50:1 for major currency pairs.
This means that you can place a maximum of $250,000 ($5,000 x 50) in currency trading positions.