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What is it Pip, Lot and Leverage?

When one is not familiar with the most relevant words in forex trading, participation in the foreign exchange market is difficult. The trader experiences pips, lots, and leverage in every forex exchange. These important words are influences that have a huge influence on the improvement of your trading account. That is why our guide describes what they are all about in-depth.


Pip, Lot, Leverage - What is it?




The foreign exchange market is often subject to constant exchange rate fluctuations, even though the fluctuations are not as strong as in other markets. The changes are very slight, so the majority of currency pairs after the decimal point are given at four digits. 


 

What is Pip?

 

A pip denotes the smallest change that a currency rate produces, so the change in the fourth decimal place is typically represented. The number of pips is the critical measure in which a trade's benefit or loss is seen.

 

For most currency pairs, a pip is equal to one-hundredth of one percent of a one-ten thousandth. The USD/JPY rate is a special case here since only two decimal places are normally seen at the rate. The second decimal position is referred to by a pip and thus corresponds to one-hundredth of the currency.

 

To benefit from even smaller price movements, many brokers now offer a further breakdown of the currency rate down to the 5th decimal place. The fifth decimal place is often called a pipette in this case.

 

The representation of how the currency is traded also differs from one pip. In half-pip steps, development is rarely measured. A pip's value depends on the currencies underlying it and can therefore vary widely.

 

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In practice, The Pip

 

Let's look at an example to better understand and calculate a pip:

 

The rate of EUR / USD is 1,1655. For one euro on the foreign exchange market, you get 1,1655 US dollars. This would be 1.1656 (+0.0001) in the case of a rising euro and 1.1654 (-0.0001) in the case of a falling euro if the price changes by one pip.

 

The value of a pip refers to the base currency and a simple formula can be used to calculate:

As a decimal number, pip/ currency rate = one pip value

 

Therefore the value of a pip from the EUR/USD=1.1655 example is:

 

0.01 / 1.1655 = Euro 0.0000858

0.02          

If you look at the currency pair USD/JPY now it behaves as follows:

 

USD / JPY = 111.59 = 111.59

 

In this currency pair, the change of one pip corresponds to ± 0.01, so either the price increases to 111.60 or it drops to 111.58. This pip's value is calculated accordingly:

 

0.01 / 111.59 = 0.000089614 US dollars or conversion: 0.000076888 euros or conversion:

0.000076888 euros.

You don't see a particularly large absolute difference if you compare the two values of the pips from our examples.

 

Euros 0.0000858 and Euros 0.00007688.

 

There is, however, an 11.5 percent difference in values, which indicates that pip values vary greatly depending on the underlying currencies. Because the absolute values of a pip are so small and profits are generated by the usual short-term trades in the one to low double-digit range, it is advisable to trade large amounts.

 

What is Lot?

 

A lot reflects a standardized volume of a financial commodity offered for purchase or exchange in the financial markets. The number of units of currency exchanged in the foreign exchange market is often referred to as lots.

 

The trader certainly has the chance to trade in the selection of regular lots for all Forex brokers. Providers with greater bandwidth often allow mini or micro-batches to be traded. This standardizes the amounts as follows:

 

  • Standard lot: the base currency is 100,000 units

  • Mini lot: 10,000 Base Currency units

  • Micro lot: 1,000 Base Currency units

 

Of course, if you open a position, you can trade many lots. To acquire 500,000 units of a currency, for example, buy five standard lots. If you want to trade smaller positions to take less risk, make sure the mini or micro lots are offered as a trading volume by the broker.


 Now let us get back to our examples. We determine the change in the value of the position per pip if we multiply the lot size by the value of the pip:


  • The value of one pip of the currency pair EUR / USD is EUR 0.00008588.

  • We assume that a standard lot is traded: 100,000 units

  • Euros 000 x 0.0000858 = Euros 8.58


 

When the price increases or falls by one pip, this value indicates which value the position gains or loses. You can of course, easily convert this amount into US dollars if you have your trading account in US dollars:


 EUR 8.58 x US$ 1.1655 / EUR = 10 US dollars.


This result is not unexpected, since, for the EUR/USD currency pair, we have 100,000 times the change in a pip that corresponds to exactly 0.0001 US dollars. Accordingly, a one pip change in the EUR/USD the exchange rate with a trading volume of two standard lots results in a change of 20 US dollars in position value.

 

Who Pays for the Whole Thing?


You may think you need enormous trading capital to trade many 100,000 units of currency if you have not heard of leverage or the 'leverage effect'. However here, with what is known as leverage, the broker helps out. You just need a small amount in the trading account to open up a position from several lots.

 

This amount is required by the broker as the so-called margin, the security deposit. It is just a few percent per transaction of the real trading volume. You can be given different leverage depending on which broker you want. In the forex market, leverage usually ranges from 20: 1 to 400: 1.

 

The leverage benefits from the margin that is needed and vice versa. For instance, if the broker offers a 100:1 leverage, this means that for a trade you just have to have 1% of the trade amount as protection on the trading account. If you buy a lot of EUR/USD, for 116,550 US dollars, you get 100,000 euros. However, you only need 1 percent of the capital for this, which is $ 1,165.5.This helps private individuals on the Forex market to trade profitably.

 

A position is automatically closed by the broker if the price progress moves in the opposite direction of the position before the deposit amount is used up so that the investor does not lose more than what is available in the trading account. A so-called margin call is also called by the broker, which gives the trader the chance to improve his protection so that the position can be kept open.

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