So How Do You Actually Make Money in Forex?
You make money in Forex by profiting on the fluctuation of the exchange rate between two currencies. This is why you are always trading currency pairs and not just a single currency. The first thing that you need to understand is that you are always buying one currency and selling the other in order to trade their exchange rate. So let’s take a look at the GBP/USD as a symbol name to explain further.
if you buy GBP/USD = you are buying the GBP and selling the USD at the same time. (a.k.a going Long)
if you sell GBP/USD = you are selling the GBP and buying the USD at the same time. (a.k.a going Short)
The first currency displayed is known as the base currency and the second is the quote currency.
GBP/USD = GBP is the base currency
GBP/USD = USD is the quote currency
So What is a Pip?
Many years ago a pip was simply the last decimal place that you could see on your chart. As time has progressed most brokers now display everything an extra decimal point which is essentially 1/10th of a pip. For many currencies this means that we have now gone to a 5th decimal place but for others it means we have gone to a 3rd decimal place. It might sound a little confusing at first but it isn’t that hard to get your head around. All you really need to know is that on any currency pair you see displayed to the 5th decimal place, it is the 4th decimal place where you start to measure pips. On any currency pair that you see displayed to the 3rd decimal place, it is the 2nd decimal place that you start to measure pips. Here are some examples to help make this clear.
If the GBP/USD changes from 1.65000 to 1.65010 = the exchange rate has moved by 1 pip.
If the EUR/JPY changes from 144.000 to 144.010 = the exchange rate has moved by 1 pip.
If the GBP/USD changes from 1.65000 to 1.66000 = the exchange rate has moved by 100 pips.
If the EUR/JPY changes from 144.000 to 145.000 = the exchange rate has moved by 100 pips.
So How is a Pip Valued?
There is a simple formula that you can follow to determine the value of a pip in either the base or quote currency of the pair you are trading.
(1 pip ÷ exchange rate) x trade size = value per pip in base currency
value per pip in base currency x exchange rate = pip value in quote currency
Let’s take a look at the GBP/USD and determine the value of 1 pip if the exchange rate is 1.65000 and we trade £10,000.
(0.0001 ÷ 1.65000) x 10,000 = £0.60606060
£0.60606060 x 1.65000 = $1
Let’s take a look at the EURJPY and determine the value of 1 pip if the exchange rate is 145.000 and we trade €10,000.
(0.01 ÷ 145.000) x 10,000 = €0.68965517
€0.68965517 x 1.65000 = ¥100
You can multiply the value per pip in base currency by the exchange rate of any currency you like. If we wanted to know our EURJPY pip value in USD then we can simply do this: €0.68965517 x current EURUSD rate.
So What is Spread? or the Bid/Ask?
Spread is the difference in Pips that you will pay when you Enter an order. To put that another way, the spread is the difference between the buy (ask) price and sell (bid) price. When trading the major currency pairs most brokers will offer a Spread of 1-3 Pips on their standard accounts. This means that if the exchange rate on the GBP/USD reads 1.6500 and you wanted to buy, then your Entry Price will be between 1.6501-1.6503, depending on what the spread was at the second you entered the trade. Spreads will vary from broker to broker and they will also vary within each broker, especially when moving between low and high volume trading times. A different type of account many brokers offer is called an ECN (Electronic Communications Network). Spreads on these accounts will be very low and you will pay commissions on your trades instead. You can look at the commission as your minimum spread, plus whatever very small spread you actually get. ECN accounts generally work out to be the cheaper way to trade when you break it down. You must, however, take care around major news events as the spreads are known to spike in size.
So What is Leverage?
In the examples above to calculate the value of a pip, £10,000 and €10,000 were used as our trade size. You are probably thinking that you don’t really want to risk that much to start and I don’t blame you. Fortunately, trading forex opens the doors for you to trade with high leverage. You can actually buy or sell £10,000 by using a much smaller amount by using leverage. If you are a US Resident you are limited to 50:1 leverage on your account. Your options to get around that are very limited but they do exist. If you live in Europe then you are limited to 30:1 leverage but it is easy to get around it. To get up to 500:1 leverage, no matter where you live, check my ECN style Brokers page. If you live anywhere else there are brokers out there offering up to 888:1! Let’s take a quick look at both extremes.
If you have a £2,000 account with 50:1 leverage.
You can buy or sell £10,000 worth for just £200.
If you have a £2,000 account with 888:1 leverage.
You can buy or sell £10,000 worth for just £11.26.
The latter example is very extreme and usually, 500:1 is the average top end. Once you have chosen a broker you will be able to select your leverage as you sign up. You could choose 100:1 or 200:1 for example. Most brokers will allow you to change your leverage as and if you want. Either way you can buy or sell a whole lot more than you actually have and that is why you are just a speculator.
So What is a Margin Call?
High leverage can be a big plus when used intelligently but before you getting too excited just remember one thing. Even though you can enter a large position using a very small portion of your account, the value of each pip still is in relation to the size of the position. This is where lack of experience results in Margin Calls. This is however easy to avoid if you have done your reading first. Let’s take a look at an extreme example so you can understand the math.
If you have a £2,000 account with 500:1 leverage you can buy or sell £500,000 on the GBPUSD using just £1000 of your account. If we stick with 1.65000 as the current exchange rate; the problem is that every pip the market moves against you it will use £30.30303030 of your remaining £1000. That means that with a 33 pip against you it’s game over. A 33 pip move against you is not uncommon and it can be very fast also. Furthermore, most brokers will exit your positions if you are using up 30% or 50% of your account. Always check your broker conditions so you know your limits.
That was an extreme example but the point is clear; high leverage can be used to barely use any of your account to be in a position. You need to be smart about your lot size and you should never risk anywhere near that much of your account on a single trade.
So What are Lots?
The final part for you to understand are these ‘lots’ that you keep hearing about. The best way to start off this explanation is with a table. The lot size that you trade will determine your actual trade size. In the examples above we have been using what are known as mini lots (10,000 of the base currency).
|Common Lot Size Name
|Base Currency Trade Size
|Trading Software Lot Size
Try not to think about the money when you are trading, just make sure your math is correct and that you are trading the right lot sizes for your account regardless of your leverage. Leverage should only be used so that any position you are in is not using much of your account.