This post is part of the free beginners Forex course
As the common saying goes, when trading you have to buy low and sell high. However, you can also try to sell high and buy low. That may sound peculiar, but in currency trading when you sell a currency pair, you are essentially buying the second currency in the pair and selling the first currency. In this case, you are buying the quote currency and selling the base currency.
Short selling also occurs in the stock market as well as the commodity markets. A short seller “borrows” a stock from its broker and sells it. The idea is to be able to buy back the shares at a later point in time at a lower price. Profit is made on the difference between the buy price and the original sell price. We will now explore how profit is calculated in the Forex market and what risks you should take into account with your trading.
In this article we will discuss
- Trading Lot Sizes;
- Pip Values and Profit;
- Trading Risks.
Lot Sizes & Contract Sizes
In Forex trading, a position is stated in terms of ‘Lots’. The most common types of lots to remember are ‘standard lots’ which represents 100,000 units, ‘mini lots’ representing 10,000 units, ‘micro lots’ consisting of 1,000 units and finally ‘nano lots’ of 100 units.
The larger the lots sizes with which you trade, the greater the potential for profit. However, this is also true with losses. It is wise to use large lot sizes with the trading setups and strategies with which you feel comfortable. If not, you should be using smaller lot sizes to reduce your risk while you are still testing the waters. In the end, you shouldn’t be risking more money than what you feel comfortable with. In general, a good rule of thumb is to risk less than 1.5% of your trading capital on any given trade. Once you have a solid grasp in trading than
Calculating Pip Values and Profit
Currency pairs are measured in pips and one pip is the smallest amount of a percent which a currency can move in relation to another currency. For most major currency pairs, they are priced to four decimal places, however, there are exceptions like the Japanese Yen pairs (they are priced to two decimal places).
- Exchange Rate Example: EUR/USD = 1.30
- This means 1 Euro = 1.3 US dollars (It takes $1.30 US dollars to buy one Euro)
In order to make money from these tiny movements in the currencies it becomes important to trade larger lot sizes and this is where leverage comes in handy. Please revisit Chapter two if you are unsure as to what leverage is. Understanding how lot sizes are affected by one pip is a case of simple mathematics. Trading a standard lot size of 100,000 units we can see how one pip translates into profit.
$/Pip = (one pip/exchange rate) x Lot Size
- AUD/USD at an exchange rate of 0.9020 = (0.0001 / 0.9020) x 100,000 = $11.09 per pip
- USD/JPY at an exchange rate of 119.90 = (0.01 / 119.90) x 100,000 = $8.34 per pip
In other words, if you placed a trade to buy AUD/USD and made 110 pip profit, using the example above you will find that you have made $1,219.90 minus commissions. Your next question might be how much does it cost to buy $100,000 with leverage? This depends on your broker’s leverage amounts, but if we can assume a leverage of 200:1 it will be equal to the following:
- If the “Ask” price of AUD/USD = 0.9020. Then 100,000 units it will require $90,200 US dollars with no leverage or $451.00 with leverage! (90,200/200)
In the example above you would have made $1,219.90 with a $451.00 investment. The power of leverage is a double-edged sword: if used properly it can substantially increase your account size. However, if it is not, it can, of course, destroy your account.
What are the Risks associated with Forex?
With the information above there are also other factors that you must consider when trading a lot size of 100,000 units. Even though it requires only $451.00 to trade a lot size of 100,000 (as in the example above), it would be foolish to do so if you had only a small account size, which would risk too much of your trading capital all at once. As a general rule of thumb you should never risk more than 1.5-2% of your trading capital. Now, the only way to determine an appropriate account size to trade 100,000 units will vary greatly depending on the type of Forex strategy you are implementing. Some strategies risk less than a few pips on any given trade while others risk much more than that.
|PIP SL (Risk)||SL Amount $||Min. Account Size|
From the table above we can see how, depending on the Forex strategy you use, it will vary greatly on the amount of trading capital you require to trade a standard lot. Obviously, the larger the account size you have, the more pips you can risk without risking more than 1.5-2%.
On the contrary, if you already have an account and would like to know the lot size you should be trading without going over the 1.5-2% rule, we have created an Excel spreadsheet for you. This is an excellent free trading tool that can be downloaded here. Follow the “free download link” on the menu panel. This tool inputs live Forex data from the internet to determine the current exchange rate and is in turn used to determine your lot size based on what you are risking without going over money management principles.
The 2% risk is in general a rule of thumb that should be used when you place trades, however it is not the only money management tool that you should be using. What will happen if you risk 2% per trade and have a losing streak of 10 consecutive trades in a row? This will mean that now you have lost 20% of your entire account size. This is where trade probability and risk-to-reward will come in handy to create a profitable trading strategy, one that abides by proper risk and money management principles. More on this on a future lesson.