What is a Lot in Forex and how to calculate it?

A

“lot” is a unit measuring the volume of a currency position that a trader opens.

In other words, this is the amount of money that you as a trader invest by buying a currency to later sell it at a more favourable price.

Usually, when you want to trade, you place orders on your trading platform and these orders are placed in sizes quoted in lots.

It’s like a deck of cards. You know that one deck of cards consists of 52 cards in total. When you buy cards, you usually buy a deck.

The same goes for the lot.  

There is a standard size for a lot (100,000 units of currency), but there are also mini, and micro lot sizes that are 10,000, and  1,000, units, respectively. 

Some brokers show quantity in “lots”, while other brokers show the actual currency units or both.

Remember that the change in a currency value relative to another is measured in “pips”.

Let’s say we have enough capital to be able to open an order with one standard lot (1 lot), which we know is actually 100,000 units. 

The movement of 1 pip in a positive direction for us with a volume of 1 lot will bring us a profit of 10 USD, and the movement of 1 pip in the opposite direction will be -10 USD loss.

If you want to see any significant profit or loss, you need to trade large amounts of a currency, in order to have the advantage of this one minute change of value. 

We will now recalculate some examples to see how it affects the pip value.

USD/JPY at an exchange rate of 105.35: (.01 / 105.35) x 100,000 = $9.49 per pip

USD/CAD at an exchange rate of 1.2822: (.0001 / 1.2822) x 100,000 = $7.80 per pip

In cases where the U.S. dollar is not quoted first, the formula is slightly different.

Will you try to calculate the second one on your own? 

EUR/USD at an exchange rate of 1.1930: (.0001 / 1.1930) X 100,000 = 8.38 x 1.1930 = $9.99734 rounded up will be $10 per pip

AUD/USD at an exchange rate of 0.7600: (.0001 / 0.7600) x 100,000 = 13.1578 x 0.7600 = 9.9928 rounded up will be $10 per pip.

We can’t say that every broker uses this way to calculate pip values relative to lot size, but even if they have different conventions of calculating it, they’ll be able to tell you what the pip value is for the currency you are trading at that particular time.

Every time the market moves, the pip value will change depending on what currency you are currently trading.

What about leverage?

Then comes the question: How can I trade such large amounts, when I don’t have so much money in my account?

But this is when your broker comes though. Your broker can basically work as your bank. 

It fronts you $100,000 to buy currencies.

In exchange, you give it $1,000 as a good faith deposit, which it will hold for you but it does not mean it will necessarily keep.

You can’t believe it, right? But this is how forex trading using leverage works.

The amount of leverage you use will depend on what your broker requires as a deposit and what is the acceptable risk level for your open trade. 

This deposit is also known as margin.

Once your money is deposited into your account, you will then be able to trade. The broker will also specify how much margin is required per position (lot or amount) traded.

Taking into account the risk and the desired return on investment allows you to balance the trade.

For example, if the allowed leverage is 100:1, and you wanted to trade a position worth $100,000, but you only have $5,000 in your account.

Your broker will make you use  $1,000 as a margin(deposit)and let you “borrow” the rest.

BUT any losses or gains that occur during the trading will be deducted or added to the remaining (real) balance in your account.

Every broker decides what is the minimum security (margin) for each lot.

In the given example, the broker required a 1% margin, which means that for every $100,000 traded, the broker wants $1,000 as a margin(deposit) on the position.

Let’s take it into action! 

You want to buy 5 standard lot (500,000) of EUR/USD. If your account is allowed 100:1 leverage, you will have to put up 5,000EUR as a margin.

The 5000 EUR, in this case, is NOT a fee, it’s a deposit.

Don’t you worry! You will get it back when you close your position (trade).

The reason the broker requires the deposit is that while the trade is open, there’s the risk that you could lose money on the position! And the broker holds the deposit as collateral in case you will have losses on the trades.

Let’s say that for the moment this USD/JPY trade is the only position you have open in your account, there is a safety mechanism to prevent your account balance from going negative, meaning that if our trading losses exceeds the equity, the broker’s system would automatically close out your trade to prevent further losses.

That’s not all you need to know about how margin trading works, but we will explain it in detail later in another section. 

How can I calculate my profit and loss?

The next important thing after calculating pip value and leverage is to know how to calculate your profit or loss.

Let’s buy Euros and sell US Dollars.

The rate you are quoted is 1.2000 / 1.2003. 

You are buying Euros you will need the “ASK” price of 1.2003, the rate at which traders are prepared to sell.

So you buy 1 standard lot (100,000 units) at 1.2003.

Later, the price moves to 1.2025 and you decide to close your trade.

The new quote for EUR/USD is 1.2025 / 1.2028.

You bought euros in the beginning to open the trade, but now you must sell in order to close the trade so you must take the “BID” price of 1.2025., which is the price that traders are prepared to buy at.

The difference between 1.2025 and 1.2003 is .0022 or 22 pips.

Remember the formula? If we use it, we now have 10$ per pip x 22 pips = $220

Bid/Ask Spread

Remember, when you enter or exit a trade, you are subject to the spread in the bid/ask quote.

When you buy a currency, you will use the offer or ASK(BUY) price. 

When you sell, you will use the BID (SELL) price.

Until now you know a lot about the basic terms of how trading is happening, but do you remember it all? Let’s review some of the lingoes you have learned. 

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