Important Forex terms Pips, Leverage, Margin

There is a section on glossary on this site but I thought I would have a section for these words since they are very important in forex trading. Let’s start with pips.

What Is A Pip?

A pip is the smallest increment of price movement a currency pair can make.

For instance, 1 pip for the EUR/USD = 0.0001 and 1 pip for the USD/JPY = 0.01.

A pip is a very smallest amount that a currency quote can change and for US dollar related pairs, this amount is usually $0.0001.

It can be sometimes referred to as 1/100 th of 1% or as one basis point and this acts as a standard.

Having this standard size helps investors and traders know what kind of risk they are taking so they can protect themselves from taking huge trading losses.

If a pip was 10 basis point, this would cause more extreme volatility in the values of the currencies.

 

How To Calculate Pip Values

Let me give you an example:

  1. Let’s say USDJPY has an exchange rate of 100.10. Now lets calculate the pip value: (0.01/100.10) x 100,000=$9.99 per pip.
  2. another one, if USD/CHF is at an exchange rate of 1.4555 then what is the dollar per pip? Here’s how to calculate it: (.0001 / 1.4555) x 100,000 = $6.87 per pip

 

What Is  Forex Leverage?

To make money from these small increments of price movement, one needs to trade larger amounts of a particular currency in order to make any significant profit (or loss).

 

This is where forex leverage comes to play.
So we need to know now how lot size affects the value of one pip.

 

Let’s work through some examples:
We will assume we are using standard lots, which control 100,000 units per lot.

 

Let’s see how this affect the value of pip.
1) EUR/JPY at an exchange rate of 100.50 (.01 / 100.50) x 100,000 = $9.95 per pip

2) USD/CHF at an exchange rate of 0.9190 (.0001 / .9190) x 100,000 = $10.88 per pip

 

In a currency pairs where the U.S. dollar is the quote currency, one standard lot will always be equal to $10 per pip, and one mini-lot will equal $1 per pip, while one micro-lost will equal .10 cents per pip, and a nano-lot is one cent per pip.

 

You may most likely have heard this saying :

“Leverage is a double edged sword”

What this means is that in forex trading, you can control a large amount of money with a very small deposit, which is called a margin.

So what this really means is that you can have deposits in your forex trading account that are less than the full value of the position you take.

Leverage in forex trading is simply expressed as ratios: 1:1, 1;50, 1:100, 1:200, 1:400.

 

To fully understand the leverage concept, look at the table below

power of leverage

So how do you calculate Leverage then? Well, here’s how:

Leverage=Purchase Power/Capital Invested

Example: If your purchasing power is $100,000 and you have a deposit of $1,000 in your forex trading account, then what is your leverage?

 

$100,000/$1000=100. Your leverage is 1:100.

 

So now, let’s dig deeper in into what this means when you deposit $1000 into your forex trading account:

  • for every $1 you deposit, the broker gives you $100 margin.
  • so for $1000, the broker gives you a $100,000 margin.
  • so for just having a $1,000, you control $100,000  for trading purposes.

So that is a very basic simple explanation of what forex leverage and how to calculate it.

For every trade you place, you should know the exact amount you are risking. The amount that you are risking must be something manageable i.e if you lose it, you won’t cry over it. Remember there is no definite trade in Forex and any trade you take can result in a loss. So expect trading losses as part of the process of forex trading.

Leverage is the ability of a trader to influence a system a system to gear his account to a position greater than his total account margin.

 

Take for instance; if a trader has $2,000 of margin in his account and he opens a $200,000 position, he leverages his account by 100 times, or 100:1. If he opens a $400,000 position with $2,000 of margin in his forex account, his leverage will be 200 times, or 200:1.

 

Note that, increasing your account leverage magnifies both your gains and losses.
If you want to calculate the leverage you used, divide your open positions total value by the balance of total margin in your trading account.

 

For instance, if you have $20,000 of margin in your account and then you open one standard lot of USD/CAD (200,000 units of the base currency) for $200,000, your leverage ratio is 10:1 ($200,000 / $20,000). If you open one standard lot of USD/JPY for $150,000 (100,000 x USD/JPY 1.5000) your leverage is 15:1 ($150,000 / $10,000).

 

What Is Forex  Margin?

Forex margin is the deposit required to open a trade or maintain a trade.

Margin can be “used” or “free”.

What does it mean?

Well, a used margin is the amount of money required to maintain your open trade.

Free margin is the amount available for you to open up new trades.

 

Let me give you a simple example:

  • If the forex brokers required margin to place  1 standard lot(contract) order is $1,500 then it simply means that you actually have to have $1,500 in your trading account before you can open a 1 standard lot trade.

 

Now, let’s assume that you placed a sell trade and your profit is now  $1,500 and you have not closed that trade yet. That means you now have a free margin of $1,500 which you can use that free margin to open another trade. So you can actually have two trades running at the same time.

 

However, if your trading accounts below the minimum required to maintain an open trading position in the market, you will get a margin call from your forex broker which means you need to add more money into your trading account maintain your open trading positions or if not, you have to close your position.

Many times, the forex broker will close your open positions if you have a margin call and you do not take any action. This is done to protect brokers as well as part of their risk management process.

 

Those three terms are important in trading and you should understand them. You can learn about other Forex terms in the glossary section.

Click here to go to the next lesson and learn about Forex scams to avoid. Alternatively, you can go back to the introduction to forex page with all the lessons.

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