A pip is the smallest unit of measurement in Forex Trading.
Basic Trading Math: Pips, Lots, and Leverage
Pip refers to the fourth decimal of the currency quote if the currency pair has either fourth or fifth decimal value. If the pair quotes only decimals up to second or third, then pip is the second decimal value. Japanese yen pairs are the ones that quote up to two or three decimal.
For better understanding, let us define the currency quote first
What is a Currency Quote?
A currency quote refers to the value to which one currency is exchanged for the other.
As you are aware by now, currencies are denoted in pairs.
The left side of the currency pair is the Base Currency.
Whereas the right side of the pair is the ‘counter currency’ or ‘Quote Currency’.
As per this example, you need to pay 1.13631 USD to get 1 Euro.
Suppose if you want US Dollars for Euro, you need to pay 0.88004 Euro to get 1 Dollar.
Simply divide 1/1.13631.
Bid & Ask
There are two parties in a Forex transaction: a buyer and a seller.
The buyer ‘bids’ for a currency pair with a quote and the seller counter bids with an ‘Ask’ quote. If the bid quote meets the ask quote, it settles the transaction.
In forex, if you put a buy order, your broker executes it at the Ask rate.
Likewise, the sell order is completed at the Bid rate.
Even if you put a pending buy order, your order is executed exactly only when ask retracts to your order price.
The difference in your bid and order execution price is the prime revenue for the forex brokers.
The difference between the buy and ask quote is Spread.
Hence it is essential to choose a broker offering Lower spread.
The fifth decimal which we neglect often is the Pipette. Therefore, one can assume 10 Pipetter=1 Pip.
Back to Pip
If EUR/USD moves up from 1.13631 to 1.13731, its an increase of 10 Pips.
Likewise, if USD/JPY moves up from 113.031 to 113.131, its an increase of 10 Pips.
(Remember, for JPY pairs, second decimal is the pip).
In the same way, if the EUR/USD moves from 1.13572 to 1.13472, its a decrease of 10 Pips.
A lot is the unit for the measurement of base currency. To make the currency traded standard, brokers deal in lots.
How Leverage Works in Forex
There are 3 types of lots, on the basis their size.
Standard Lot: 100,000 units of base currency.
Mini Lot: 10,000 units of base currency.
Micro Lot: 1,000 units of base currency.
Calculation of Profit by Pips
If you trade 1 Standard lot and make a profit of 10 Pips, you gain $100.
Likewise, if you trade 1 mini lot and make a gain of 10 Pips, you end up with $10.
So, for a micro lot, as you anticipate, for the same 10 pips profit, you gain only $1.
As per this theory, you need $100,000 to trade EUR/USD to make a meager profit of $100 with a 10 pip move to your favor.
It is just a theory.
You don’t need to be a Billionaire to trade Forex.
You can trade with as little as $20 in your Forex trading account.
Leverage and Margin
Leverage is just like a credit card. For each $1 you hold, your broker offers leverage of 1:100, i.e., your $1 is equivalent to $100.
To provide leverage, your broker locks up a particular portion of your capital, known as margin.
You cant use the locked margin until you close the open order.
If Leverage is bank credit, the margin is the lien marked, just in case things go haywire.
The leverage and margin vary from broker to broker.
Some even offer up to 1:888.
However, leverage is just like credit, when you over-leverage, it can offset you and sometimes you end up losing more than your capital. But if you under leverage, you don’t get to maximize your profits.
So, to be a good trader, one needs to use optimal leverage.
Every currency pair bears an interest rate.
When you a buy a currency pair, you buy its base currency and sell its counter currency.
If you’re long in a currency pair, you get the interest for the base currency.
But, you’ve to pay the interest for the counter currency. The vice versa for a short pair.
The broker simplifies the process and cuts to the chase, they calculate the difference and if it is net positive, will add to your position. Likewise, the broker substracts your account, if it is a net negative.
Pip is the unit of measurement in Forex Trading.
The fourth decimal in non-Japanese currency pairs and the second decimal in Japanese Yen pairs is regarded as Pip.
The broker executes a buy order at the Ask price and the sell order at the Bid Quote.
Spread is the difference between Bid and Ask price.
The broker holds a margin amount and powers your trading account with leverage which empowers you to buy or sell assets 500 times your capital.
Swap rate is the interest rate you either pay or get, for holding a currency pair overnight.