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Pips, Lots, and Leverage — oh my! 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. 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.

As discussed in previous library articles, a pip is the smallest price change a given exchange rate can make. 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. 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. We will express these examples where the USD is quoted first in order to express the value of the pip in terms of U.

Since the rate is quoted to the fourth decimal place then we can use our trusty formula of: Using our same logic and formula we can calculate the value of a pip:. Well, in the following discussions about lots and leverage you will see how pips can add up quickly.

What happens when the exchange rate of a currency pair is not expressed to four decimal places? That seems like a whole bunch of work to calculate such small value. 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. 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.

We do this by using our pip formula from before and multiplying it by your lot value, so it now looks like this:. The first number in the spread is known as the bid price and the second is known as the ask price. For our example — remember dear Aunt Matilda? This means the exchange rate at which you can sell your lot the bid price has increased to 1.

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, Sounds confusing, but the following formula shows how simple it is using our example:.

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:.

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 How is this possible? Since Forex fluctuations are typically small a one cent or 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. Our profit is still the same, but our rate of return is MUCH greater. Would you rather earn 0. 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.

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. Types of Trade Orders. We respect your email privacy. Please note that Forex trading involves substantial risk of loss, and may not be suitable for everyone. The Pip Exposed As discussed in previous library articles, a pip is the smallest price change a given exchange rate can make.

Pip Examples Each currency has its own value which is usually expressed in relationship to another currency. Using our same logic and formula we can calculate the value of a pip: A Lot Explained Wheeewww.

We do this by using our pip formula from before and multiplying it by your lot value, so it now looks like this: Sounds confusing, but the following formula shows how simple it is using our example: So, our actual profit from the money Aunt Matilda left us can be derived as follows: Leverage applied Leverage allows Forex investors to gain a much higher return on their initial investment it also allows for higher losses as well.

Margin Call A natural question that emerges when discussing margin trading is what happens if I lose more money than I have in my account? Pop Quiz 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.