Forex Terminologies and the simple calculations behind them

FUNDAMENTAL FOREX TERMINOLOGIES AND THE SIMPLE CALCULATIONS BEHIND THEM

What is a pip

In a currency pair quote, the pip is the number in the fourth place after the decimal point.

For example, if the EUR/USD is at 1.12365, 6 is the pip.

But there are currency pairs like US Dollar against the Japanese Yen where the quote looks like USD/JPY 135.627

So, do you give up on such a pair? Well, not so fast. The pip in that case is the number in the second place after the decimal point. In that case, the pip will be 2.

Price Terminologies

Bid price = The price that you can sell at, at the moment.

Ask price = The price that you can buy at, at the moment.

Spread = The difference between the bid and ask price. B book brokers have a spread, from which they make a small profit from, but at most times, they charge no commission.

Swap = The interest that a broker can charge you if you keep a trade overnight.

Other Common Terminologies

Going Long = Buying

Going Short(Shorting) = Selling

What is leverage

Leverage is the money that you borrow from your broker.

It is shown in form of a ratio, e.g. 1:100

Let’s say you have a $1000 trading account and you select a leverage of 1:100 when creating your trading account.

$1000*100 = $100,000

That shows, you can place trades like a person who has a $100,000 trading account.

Leverage is good but is dangerous if misused. Some countries like the US have a leverage limit of only 1:50, but even if you are in the US, you can use overseas regulated brokers who can offer huge leverages if you need them.

Misconceptions about leverage

Most people say that huge leverage by itself is risky but that is not true.

Huge leverage can only become risky in two cases:

1. When you enter into very many trades at the same time because the leverage allows you to do so.
2. When you enter into a trade with a huge lot size, because the leverage allows you to do so.

What is Lot Size

Lot size is the amount of currency units that you are entering in a trade with

The most used lot sizes in the forex market are:

1. Standard lot, also known as 1 standard lot, which equals 100,000 units of the base currency
2. Mini lot, also known as 0.1 standard lot, which equals 10,000 units of the base currency
3. Micro lot, also known as 0.01 standard lot, which equals 1,000 units of the base currency

You can see trading those lots need a lot of money(currency units). That is why you need leverage.

In MetaTrader 4, there is a section where you select the lot size that you want to enter a trade with. I will guide you in my MetaTrader 4 tutorial.

What is pip value

In the previous sections, we looked at what pips and lots are.

Pip value is based on pips and lots, so we had to learn them first.

Pip value, basically tells you how many dollars you will make or lose for each pip movement.

For example, you bought the USD/CAD pair when it was at 1.31235 and then it rose to 1.31245. That is considered to be a rise of 1 pip.

In that case, how much money will you have made? Well, that will depend on the lot size you entered the trade with.

Pip value calculation

To get the pip value, the simplest method is to multiply your lot size by 10, with the Japanese Yen pairs being an exception to this formula, where you multiply the lot size by 1000

Note that the pip value that you get in those calculations is usually in the quote currency. In our USD/CAD case, our quote currency is the Canadian Dollar, so the pip value you get will be in Canadian Dollars.

If you had bought 1 standard lot of USD/CAD, the pip value would be 1*10 = 10 CAD. If the pair finally went up by 5 pips you would have made a total of 10*5 = 50 CAD.

If your trading account is in US Dollars, the broker will automatically convert your profits and loses to USD. In most pairs, the quote currency is usually the USD, so there is no that conversion stuff.

But if you want to know how to convert that gain to US Dollars manually, just divide the 50 CAD by the price(exchange rate) which you bought the pair e.g. 1.31235. That is: 50/1.31235 = 38.1 USD

Main purpose of pip value calculation

But do you need to do all that pip value calculation stuff? Well, the good news is no. You don’t need to.

The whole purpose of learning pip value and how it relates to the lot size, is to introduce you to the basics of one of the major pillars of successful forex trading known as risk management and position sizing.

The good thing, is that there is a free software you can use to calculate the position size(lot size) to use whenever you are placing a trade, without calculating the pip value.

In my risk management and position sizing post, you will be able to learn more about position size and how to calculate it in a few seconds using a free software.