Forex: Leverage, Pips & Lots
In addition to high liquidity, the advantages of forex trading include low trading costs and the use of leverage.
Trading on the forex market is based on crossing between two values. The comparison of the value of one currency against another is called «exchange rate» and can be expressed in two ways:
- how many units of the first currency are required to buy or sell one unit of the second currency (uncertain for certain);
- how many units of the second currency are required to buy or sell one unit of the first currency (certain for uncertain).
To avoid confusion, a convention has been established whereby the base (or «certain») currency is placed as the numerator, while the quote or counter (i.e. «uncertain») currency is the denominator. The uncertain currency is the one whose value varies when the price changes. For example, if the EUR/USD quotes 1.0945, that means that it takes 1.0945 dollars to buy 1 euro.
On the forex market, you can take both long and short positions on the different exchange rates.
For instance, going long on EUR/USD means that you expect the value of the euro to increase against the dollar, therefore a rise in prices. A short position implies that you expect the opposite, i.e. that the dollar will appreciate against the euro, therefore a fall in prices.
Low trading costs and the use of leverage
In addition to high liquidity, the advantages of forex trading include low trading costs and the use of leverage. In terms of trading costs, no fees actually apply to trading on foreign exchange markets. The cost is determined by the bid-ask spread offered by brokers. This is the difference between the first bid price and the first ask price on the trading book. The bid is the price at which the broker is willing to buy the currency (and therefore the price at which the investor can sell the currency), while the ask is the price at which the broker is willing to sell the currency (and therefore the price at which the investor can buy the currency).
Let’s assume that the bid-ask spread on the EUR/USD exchange rate is: EUR/USD BID/ASK 1.0984 1.0986 If you want to buy the currency you can do it by placing a market order at 1.0986 (i.e. an order that hits the ask price). The spread is expressed in pips. For more liquid currency pairs (such as EUR/USD or USD/JPY), the spread is less than 1 or 2 pips, while for less commonly traded currencies the spread can be up to 3 to 5 pips.
Pips and lots
The term pip (which is the smallest movement that an exchange rate can register) is also usually used to express movements in quotes. For example, if EUR/USD rises from 1.1016 to 1.1058 it means quotes have gone up by 42 pips.
Currencies are traded in multiples of a minimum number of units called lot. Convention has it that the minimum lot size is 100'000 units, but traders can exchange mini lots of 10'000 and micro lots of 1'000 units of the base currency. Let’s assume that we buy EUR/USD at 1.0986 and that the price later moves to 1.1016. A trade involving 100'000 units would produce the following profit: P&L = (1.1016–1.0986) * 100'000 = 0.0030 * 100'000 = USD 300 Thus, the 30 pips of profit equal a gain of USD 300 on a lot of 100'000 units. A mini lot of 10'000 units would have generated a profit of USD 30, and a micro lot of 1'000 units a profit of USD 3. The pip is the basis for calculating profits in forex trading. In the example above, 1 pip in EUR/USD on a lot of 100'000 units comes out to USD 10. This makes it is easy to calculate profit or loss. For example, with a position of 100'000 units of EUR/USD, a change of 40 pips results in a $400 profit or loss (100'000*0.0040 = 400 or 40 * 10 = 400).
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DISCLAIMER
Trading foreign exchange, spot precious metals and any other product on the Forex platform involves significant risk of loss and may not be suitable for all investors. Prior to opening an account with Swissquote, consider your level of experience, investment objectives, assets, income and risk appetite. The possibility exists that you could sustain a loss of some or all of your initial investment and therefore you should not speculate, invest or hedge with capital you cannot afford to lose, that is borrowed or urgently needed or necessary for personal or family subsistence. You should be aware of all the risks associated with foreign exchange trading, and seek advice from an independent financial advisor if you have any doubts. The content of this website represents advertising material and has not been submitted to nor approved by any supervisory authority.
