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Leverage and Trade Basics

Breaking down the different parts of a single Forex trade:

In this article we are going to uncover a handful of much needed basics of trading forex like using and understanding leverage as well as what goes on every single trade you make.

How Do You Read A Quote?

In stocks you are trading one stock for example which might be an instrument like Google. In forex, you one currency is always having it’s value tested against the value of another currency. That is why you always see forex instruments quoted in pairs.

For example, GBP/USD at 1.4022 shows how much one British Pound (GBP) is worth in U.S. dollars (USD).

What Is A Pip?

A pip is the smallest increment measured in the movement of currency. Most currency pairs, except Japanese yen pairs, are quoted to four decimal places. This fourth spot after the decimal is noted as 100th of a cent. Every point in that place in the quote moves is 1 pip of movement. For example, if GBP/USD rises from 1.3045 to 1.5045, that particular currency has risen 200 pips.

Here’s a few examples:

Instrument: GBP/USD
Long entry at 1.3045
Exit at 1.5045
Profit/Loss = Profit of 200 pips

Instrument: EUR/USD
Long entry at 1.4050
Exit at 1.4200
Profit/Loss = Profit of 150 pips

Instrument: USD/JPY
Short entry at 142.50
Exit at 142.00
Profit/Loss = Profit of 50 pips

What Is A Lot?

A lot is the smallest trade size available. Most brokers offer accounts that have a standard lot size of 1,000 units of currency. The beauty is you can use different lot sizes that match your objective, as long as they are in increments of 1,000 units like 3,000; 5,000; 10,000; 100,000 for example.

  • Standard Lot
  • Mini Lot
  • Micro Lot

Standard Trading Accounts
This is the most common account. And if you’re not careful you can get caught up trading with this type of  account without the proper capitalization. This account affords you access to standard lots of currency, each of which is worth $100,000.

And you don’t need to have $100,000 of capital in order to trade. The rules of margin and leverage (typically 100:1 in forex) allow you to trade a standard lot with as little as $1,000.

Pros

Since a standard account requires sufficient up-front capital to trade full lots, most brokers provide more services and better perks for forex traders who have this type of account.

Also, with this type of account each pip, depending on the currency you are trading has the potential of being worth $10 or so, if a position moves in your favor by 10 pips during the course of a trade your (unrealized) gain will be $100.

Cons
Capital Requirement
In most cases, brokers call for standard accounts to have a minimum starting balance of at least $2,000.

Loss Potential
In the paragraph above we discussed if a currency moves in your favor by just 10 pips you could have theoretically gained $100. Now, just like that $100 if a position moves in your favor, if price goes in the direction of opposite of your intention, you could lose that same amount in a 10-pip move. As you may have figured, this could easily be a double edge sword for the reckless or uninformed trader.

Well capitalized, experienced traders are better starting with this type of account than a novice using his $1000 savings to get started.

Mini Trading Accounts
A mini trading account is just a trading account that allows forex traders to make trades using mini (smaller) lots. A mini lot is equivalent to $10,000, as opposed to a standard account, which trades lots 10-times that size.

Pros

Low Risk
Newer traders can place trades without the risk of blowing their account. One can also get acclimated to the forex climate without back thought that they putting up the financial lives on the line every trade.

Low Capital Requirement

If you are looking to get you start without taking out another mortgage, this is awesome way to do so as you can generally get started with as little as $500.

Most brokers will offer the opportunity to trade mini accounts as well. For most rookie and novice traders, I recommend this type of account or the mini account, over trading a demo/paper account for various reasons.


Con
Low Reward
We all know that with high risk can come high reward, but the opposite is also true: With low risk comes low reward. Mini accounts that trade $10,000 only realize a $1 gain for every pip of positive movement, as compared to $10 in a standard account.

Micro Trading Accounts

As you can probably guess just looking at the name, a micro trading account is one that lets you risk even less than money than the aforementioned ones. In most brokerage accounts, a micro lot is equivalent to $1,000, as opposed to a mini account, which trades lots 10-times that size. This means, if we have a 10 pip gain on trade our unrealized gain is worth $1 as each pip is worth about .10 cents give or take. As you can see much less risk but also much less gain.

Most brokers will offer the opportunity to trade micro accounts as well. For most rookie and novice traders, I recommend this type of account or the mini account, over trading a demo/paper account for various reasons.

Pros
Low Risk
By trading in much smaller increments, newbie traders can place trades with much less risk of blowing their account. They can also try out different strategies with little to no risk.

Low Capital Requirement
The majority of micro accounts can be opened with as little as $100. With the margin requirements being roughly $10 per lot. The barrier to entry has literally been stripped away.


Con
Low Reward

As discussed earlier, micro accounts trade in $1,000 lots and their pip movements are worth only 10 cents per pips. Again, even with little to no forex experience starting with this type of account is a definite headstart over trading with a demo paper account. You have some skin in the game. May not be much is it some.

What Is Leverage/Margin?

All trades are executed using borrowed money. This is called leverage. For example, leverage of 50:1 allows you to trade with $1,000 in the market by setting aside approximately $20 as a security deposit. This means that you can take advantage of even the smallest movements in currencies by controlling more money in the market than you have in your account. On the other hand, leverage can significantly increase your losses. Trading foreign exchange with any level of leverage may not be suitable for all investors.

Leverage is using others people’s money to buy or sell contracts or securities. Here is another example: If a broker offers a 50:1 leverage, it means you are allowed to borrow 50-times the amount of money in the account to make a trade. So, if a contract is worth $10,000 and the broker is offering 50:1 leverage, a trader will only need to have $200 in his or her account to purchase the contract worth $10,000.  ($50 for every dollar put up by the trader, thus $50 x $200 = $10,000)

What is margin?

The specific amount that you are required to put aside to hold a position is referred to as your margin requirement. Margin can be thought of as a good faith deposit required to maintain open positions. This is not a fee or a transaction cost, it is simply a portion of your account equity set aside and allocated as a margin deposit. (i.e. the $200 security deposit from the previous example.)

What is margin call?

Continuing with the previous example, if your trades goes south and the money in your account becomes less than that $20 deposit you set aside, your trade would be immediately canceled.  You also wouldn’t be allowed to place another trade until you deposited more money into your account.

Putting it all together:

Let’s say Johnny Trader wants to enter the forex market and only has $1000 to dedicate to his new trading venture. If he were trying to trade stocks, Johnny would be completely out of luck as he couldn’t even be allowed to trade per the stock day trader minimum capital rule.

But in Forex, not only can he trade but he can dictate his leverage status so that if you wanted to only risk pennies or dimes on the dollar he could very well do so. Or if he has a bigger tolerance for risk he could set his sights on using a mini account.

He would rather spend his first few months learning and not blowing through his account. So he decides to trade one mini lot of the GBP/USD.

1 mini lot = 10,000 units. Meaning each pip will be worth $1, roughly speaking. And his broker has a margin requirement on 1 mini lot being $100 of account per lot. Meaning that he has put on only $100 of his account down as a deposit for this one trade. Leaving, him technically $900 left of usable margin to make other trades, if he wants to. But to keep things simple this is the only trade he will take for now.

Now, following sound money management principles, Johnny only wants to risk 3% of his account on any given trade. Therefore, with his $1000 he can only afford to lose $30 only any given trade. Ultimately, meaning if he is wrong, since each pip is worth only $1 he will lose a maximum of $30 on this trade should it not work out. Leaving Johnny with $970 left in his account to make future trades if he loses of course.

He decides the place a trade. Assume he initiated the trade when the exchange rate was GBP 1 (the base currency) = USD 1.3600 (GBP/USD = 1.36), as he is bearish on the British Pound and expect it to decline in the future.

And it does just that. The price drop to 1.3500. That’s a 100 pip move. Meaning he has $100 is unrealized profit. Putting his account equity at $1,100. So being the wise man he is, Johnny happily takes his money off the table securing what was recently an unrealized gain of $100. Now that he has officially closed the trade he has $100 in realized profit. Making his account balance officially $1100.

This are just simple explanations and examples. The best way to learn in to get in the game and put some money on the line. Now, go trade.

 

 

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