How do you trade forex? It may seem a little confusing at first, but really, it is quite simple.
Forex is a leveraged financial instrument, as is Options, Futures, CFDs, Warrants etc. So this is nothing new.
You trade Forex in ‘lots’. That is basically the industry standard, but there are brokers out there that do things slightly different. For example, Oanda trades in ‘units’, but they can be easily converted to a lot size equivalent.
Lots are known by different names, depending on how much currency they represent.
There is a standard lot, a mini lot and a micro lot.
One standard lot is equal to 100,000 units of the base currency
One mini lot is equal to 10,000 units of the base currency, and
One micro lot is equal to 1,000 units of the base currency.
How many lots you can buy or sell depends on a few things.
– your account balance
– your nominated trading leverage, and
– how much you are willing to risk on the trade?
This is when I mention the words ‘margin’, ‘leverage’ and ‘risk’. All words that are important, but no need to get all stressed about them as they can all be controlled and I’ll show you an easy way to stay out of trouble.
Margin just refers to the money you have in your account that is available to trade with. As stated earlier, Forex is a leveraged instrument, so if your broker offers you 100:1 leverage, then for every I unit you have in your account, you can control 100 units. Some brokers offer up to 400:1 leverage. If you are over leveraged and a trade goes against you, and you decide not to take any action, your broker will close the trade on your behalf to protect their interests, even though you may have blown your account out. It is not something that concerns me as my risk is controlled on all trades. Risk just refers to what you are willing to risk on any particular trade, in terms of dollars.
Now to the lot size and the equivalent pip value. Just to refresh your memory, if the EUR/USD moved from 1.3924 to 1.3928, it has moved a total of 4 pips, and if the USD/JPY moved from 95.23 to 95.19, it also moved 4 pips. Pretty straightforward so far.
If I was trading 1 standard lot ($100,000), then each pip is worth US$10. So in the above EUR/USD example of the 4 pip move and you were trading 1 standard lot, 4 pips is equal to US$40. The same US$10 per pip also applies to the GBP/USD, AUD/USD and NZD/USD.
That’s the easy part. Now all the other forex pairs aren’t quite as simple due to the fact that the USD is not the quote or counter currency. So what you have to consider here, is the currency conversion between the two pairs and the maths can be a little confusing. Me, I keep it simple, and consider all pairs to have a 1 pip value of US$10. Just about all of the forex pairs, except the EUR/GBP have a pip value of less than US$10, and most of these are just under that level, but they do fluctuate with currency variations.
If you do need to know the exact pip value, there are plenty of free web sites with a built in calculator to do all the maths for you.
The majority of traders either trade standard lots or mini lots. As stated earlier, Oanda is slightly different here as they trade in units, which can be very useful for precise money management.
Okay if 1 pip is equal to US$10 on a standard lot ($100,000), then 1 pip on a mini lot ($10,000) must be equal to US$1, and 1 pip on a micro lot ($1,000) is worth $0.10. Simple! And to keep it very easy and simplified, just consider every Forex pair the same. I know a USD/JPY pip isn’t US$10, but it is close enough for me not to worry about it’s exact value. If your style of trading is affected by the exact price of pips on the Forex pair your are trading, then you will have to use something like the calculator above to work out the exact values.
Let’s get into a trade example:
I have $2,235 in my trading account, and I am happy to risk 2% on each trade.
I’m in my brokers account looking at their charts and I see a nice set up on the EUR/USD where I am looking at buying at 1.3928. I am going to place my stop (stop loss) 30 pips below at 1.3898. So my risk on this trade is 30 pips.
Now I need to know what my position size will be, where I am risking no more than 2% of my overall account balance of $2,235. This actually equates to $44.70.
The easy way to work this out is by using the following:
Account Balance multiplied by risk percentage, divided by risk, equals position size.
In this trade, the maths would look something like this:
$2,235 x 2% = $44.70
$44.70 / 30 pips = 1.49
Therefore my position size on this trade would be 1.49 mini lots. You would have to round this down to either 1 mini lot, or 1.4 mini lots if your platform allows this trading size.
If you are unsure of the position size, whether it is in standard or mini lots, just do the maths backwards to confirm. You know the maximum risk is $44.70 on this trade. If you went into the trade with 1 mini lot, you know each pip is worth $1, so if you were stopped out, then you would have lost $30, which is under your max risk of $44.70, due tot he fact you had rounded your position size down.
Just another example with a much larger account balance and a different risk percentage and stop placement.
Account balance is $37,840, your trade risk is 3%, and you are placing an order to sell the GBP/USD at 1.4562 with a stop at 1.4607, which is 45 pips away.
Let’s do the maths to work out my position size.
$37,840 (Account balance) x 3% (risk percentage) = $1135.20
$1135.20 (max risk) divided by 45 (stop) = 25.226′
Therefore my position size would be 25.226′ mini lots, rounded down to 25 mini lots or 2.5 standard lots.
Do the maths in reverse if you want to double check your position size. You know your max risk is $1135.20, and your stop is 45 pips, and each pip is worth $10 on a standard lot. If you were to lose 45 pips with 2.5 lots, then 45 x 2.5 x 10 = 1125, which is under the $1135.20 risk.
It may be a little confusing at first, but it is very simple once you get the hang of it. By using this formula, you should never have to worry about leverage, margin or risk. They just don’t come into it. But having said that, it all depends on your risk percentage levels and your actual trading methods. You do need a successful trading method, because if you don’t and you were only risking say 2% per trade, you will eventually blow out your account. It will just take a bit longer to achieve this than if you were risking 10% on each trade.
There was a fair bit of information on this article, and it was pretty important information. In the next article, I’ll go into this a little further and talk about risk etc.