What is pip? How to use leverage in forex trading?
What is Pip?
A haunting question for many before starting their trading career. First, let us how to read a forex quote which can help understand the pip.
Reading A Forex Quote
For an absolute beginner in Forex, it is very important to understand how to read a Forex quote.
Here is how a Forex quote looks like:
EUR/USD = 1.1194
The currency on the left side is called ‘base currency’ and the currency in the right is called ‘quote currency’ or ‘counter currency’. The price of the base currency (EUR) is quoted in relation to the quote currency (USD). The quote indicates how much of the counter currency is needed to buy one unit of base currency. So, in the above example, it means you need $1.1194 to buy one Euro.
Let us see another example.
USD/JPY = 111.62
Here, USD is the base currency and JPY is the counter currency. As you may have guessed, it takes 111.62 Japanese Yens to buy one USD.
When you look at the two examples, you can notice that EUR/USD is quoted with 4 decimal places and USD/JPY is quoted only with only two decimal places. To understand the importance of these decimal places, we need to understand what a ‘pip’ is. Let us discuss some basic Forex terms in the next section.
Pip is the smallest unit of measurement to indicate the change in value between two currencies. If the price of EUR/USD has changed in the last 4 hours, a trader would want to know how many pips it had gone up or down.
For most of the currency pairs, a pip is usually the fourth decimal place of a quotation.
For example, if EUR/USD went up from 1.1190 to 1.1192, then it means it went up by two pips.
If the same pair went from 1.1192 to 1.1202, then it has gone up by 10 pips. Some brokers may include a fifth decimal place, but it is not considered while calculating a pip.
But there are exceptions. For currency pairs with Japanese Yen, a pip is the second decimal place of a quotation. So, If USD/JPY went up from 111.62 to 111.65, the price has gone up by 3 pips.
As mentioned before, some brokers use a 5th or 3rd decimal place (for JPY).. Those extra decimal places are included to fractional pips called pipettes.
Bid & Ask
When the broker quotes you the price, he actually gives you two prices: bid and ask
If you want to go short, then bid is the price at which your broker is willing to buy the base currency from you in exchange of the quote currency.
If you want to go long, then ask is the price at which your broker is willing to sell the base currency to you in exchange of the quote currency.
Let us say that the quote price for AUD/USD is 0.75843 / 0.75847. The price on the left side is bid and the price on the right side is ask.
So, if you want to sell, your broker will buy AUD at 0.75843. If you want to buy, your broker will sell AUD at 0.75847.
The difference between the bid and ask is known as the spread.
When you trade Forex, you trade in specific amounts called lots. A lot just means the number of currency units that you trade.
There are different types of lots which are standard lots, mini lots, micro lots and nano lots.
A standard lot = 100,000 units.
A mini lot = 10, 000 units
A micro lot = 1000 units
A nano lot = 100 units
A standard lot is mentioned numerically as number 1. A pip earned using a standard lot is equal to $10.
So if you place a trade using 1 standard lot and earn 5 pips, you would have earned $50.
A mini lot is expressed as 0.1 and gives you $1 per pip.
A micro lot is expressed as 0.01 and gives you $0.10 (10 cents) per pip.
You can actually choose a certain number of a specific lot; for example, you can choose various lot sizes like 2, 0.4, 0.03 etc. A trade with lot size 0.4 with a profit of 5 pips will give you an actual profit of $20.
Leverage & Margin
Let us say you want to open a trade with a standard lot size, but you have a very small amount of capital. Does that mean you cannot trade with a standard lot size?
No. The good news is, you can still trade with higher lot sizes even if you don’t have the sufficient capital to cover it. We can do this by making use of leverage.
A broker will allow you to trade a standard lot of 100,000 units by asking you to put down a small amount of deposit like $500. This $500 is the margin in this case. Margin is usually expressed as the percentage of the total amount. In this case you are putting down 0.5% of the total amount that you are going to trade with. (100,000/500 * 100)
When the same is expressed in the ratio of the total amount to the margin amount it is called leverage. In this example, 200:1 is the leverage set by the broker. The leverage varies for each broker and it is usually expressed in the ratio.
Simply put, a leverage of 100:1 allows you to trade $100 by putting down $1.
Note that your actual capital that you start with will be higher than the margin that is required by the broker. For example, your trading account may have a total capital of $10,000 out of which $1000 may be locked as the margin amount for a trade.
Trading with too much leverage is very risky as well. Excessive leverage can either make you gain a large amount of money or lose a large amount of money. For this reason, leverage is usually called as a double-edged sword. Here are 5 Risk Management Tips That Every Forex Trader Should Know
Even though the Forex market trades 24 hours a day, each broker sets a daily cutoff time to mark the end of a trading day and the beginning of the next trading day. Whenever you place a trade, you actually borrow the currency of one country to buy another currency. So, when a trade lasts beyond the cutoff time, you will have to pay interest in the currency you have borrowed and you will earn interest in the currency you have bought.
So depending on the net interest, you will either earn or spend money as a result. But if you don’t want to earn or pay interest, you just have to close all your trades before the cutoff time. For most of the brokers, the cutoff time is usually 5 PM EST.