Forex trading is done in pairs, with one currency traded for another. You can buy and sell currencies according to the exchange rate, which constantly fluctuates on the forex market. When you trade forex, you must be aware of two things: pips and lots.
What is a pip?
A ‘pip’ is the most minute unit of price movement in a currency pair. A pip is equal to 0.0001 of the quoted price for most pairs. For example, if the EUR/USD exchange rate is 1.2345, each pip is worth $0.0001.
What is a lot?
A ‘lot’ is the standard unit of measurement in forex trading. There are three types of lots: a standard lot, a mini lot, and a micro lot. The reason for this is because people may not be able to purchase a standard lot of a currency but still want to participate in trading.
Standard lot
A standard lot is worth $100,000 (of the base currency).
Mini lot
A mini lot is worth $10,000 (of the base currency).
Micro lot
A micro lot is worth 1,000 units (of the base currency).
How do pips and lots work together in FX trading?
A pip’s value depends on how much of a currency you buy or sell. The formula is:
(pip value) x (number of micro-lots traded) = (amount gained/lost per pip)
For example, let’s say you buy one micro lot of EUR/USD (1,000 units) at an exchange rate of 1.2345. Each pip is worth $0.0001, so the value of each pip is 1,000 x 0.0001 = $0.10. If the price goes up by one pip to 1.2346, you will have made a profit of $0.10 (one pip x $0.10). Similarly, if the price goes down by one pip to 1.2344, you will have made a loss of $0.10
You must remember that the value of a pip is not always equal to $0.10, which is only the case when you are trading in micro-lots. The value of a pip will be higher or lower depending on whether you are buying or selling a standard or mini lot.
Some brokers quote prices with five decimal places instead of four (1.23456 instead of 1.2345). In this case, each pip is worth 0.00001 instead of 0.0001. Therefore, the value of each pip will be one-tenth of the above.
Some foreign exchange brokers also offer ‘mini’ and ‘micro’ accounts, which allow traders to trade in smaller increments. These accounts are sometimes referred to as ‘pennies accounts’. In this context, ‘pennies’ refers to the fractional value of a pip (0.01 of a unit).
A mini account allows you to trade in increments of 0.1 (one-tenth of a standard lot), while a micro account allows you to trade in increments of 0.01 (one-hundredth of a standard lot).
The advantage of trading in smaller increments is that it allows you to take on less risk. The downside is that your potential profits are also smaller.
What are the advantages of understanding pips and lots?
You can calculate your profit or loss more accurately
If you know the value of a pip, you can calculate your potential profit or loss more precisely because you know exactly how much each pip is worth in terms of your currency.
You can manage your risk more effectively
By understanding pips and lots, you can also manage your risk more effectively. For example, if you only want to risk losing $10 on a trade, you can calculate how many micro-lots you need to buy or sell to stay within your risk limit.
You can argue your case more convincingly to a broker
If you have a good understanding of pips and lots, you can argue your case more convincingly to a broker. It is because you will be able to show that you understand the risks and potential rewards of a trade before entering into it.
You can trade forex with Saxo Bank.
