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Pips 'n' Profits
What is a pip?
In the previous lesson we discussed spreads. Using the same quote I will explain what a pip is. The space between the 2.0404 bid and the 2.0408 ask is 4 pips. The little number at the end of each quote is the pip:
So if I enter a long position on GBP/USD at 2.0400 and it moves to 2.0450 by the time I sell that position to exit that is a 50 pip profit. The question you should be asking is "how much are those 50 pips worth?" The answer depends on both the size of the lot, as well as the currency pair involved. We will tackle 'lot size' later. For now we will use some math to figure out the true value of 1 pip.
For GBP/USD we know 1 pip is the last number of the four numbers behind the decimal point. So 1 pip would be 0.0001, to figure out its value we simply divide the current price of the pair by 0.0001.
GBP/USD = 2.0408
0.0001 / 2.0408 = 0.00004900
The problem now becomes that you have found out the value of 1 pip in GBP, but you are probably trading in USD. So you multiply 0.00004900 by the current GBP/USD value.
0.00004900 x 2.0408 = 0.00009999
Or $0.000099
I know it seems like nothing but like I said it is dependent on your lot size. When I explain lots you will understand how that $0.000099 becomes $0.99 or $9.99 or even $999 per pip.
Let's look at another example with fewer decimal places.
USD/JPY = 117.13
This time we do
0.01 / 117.13
= 0.00008537
Or $0.00008537
This time since USD is the base currency in the pair we do not need to multiply.
Now you can forget what you just read. You do not need to know any of this since your broker does all the math work for you. It is just beneficial to have some idea of how they calculate pips.
Lots of 'Lots'
Lots are what make that little $0.000099 big money. The standard lot size in Forex is $100,000 and there are also mini lots that are $10,000. On a mini account every time you take a trade you are placing $10,000 into the market. I know, I know. You do not have $10,000 to trade with. That is why your broker is nice enough to give you leverage, which I will explain next.
So with each mini lot being worth $10,000 let's say you take a long GBP/USD position at 2.0408. We figured out each pip is worth $0.00009999 on GBP/USD so now we multiply that by $10,000.
$0.00009999 x $10,000 = $0.99
If you are trading a standard lot which is $100,000 you figure it out like this:
$0.00009999 x $100,000 = $9.99
So by trading one mini lot you make $0.99 per pip and trading a standard or full lot you make $9.99. Remember though, if you lose pips you lose the same amount per pip.
Let's do another calculation, keeping in mind though that your broker will do all this for you:
USD/JPY = 117.13
0.1 / 117.13 = 0.00008537
0.00008537 x $10,000 = $0.85 Or 0.00008537 x $100,000 = $8.53
What is leverage?
Leverage turns your $100 into $10,000 or your $1,000 into $100,000. In the previous section I said that a standard lot in the market is $100,000 and a mini is $10,000. Most retail traders do not have that kind of money so your broker gives you leverage. The most common leverage is 100:1 which means for every $1 you deposit into your account, your broker will allow you to trade $100 (basically loaning you the extra money to make trades with).
Do not freak out yet soldier. If you lose they do not let you lose enough to cut into their hard earned money they loaned to you. They cut you off way before that point so you can only ever lose what you have in your account. In other words you won't fall into debt with your broker.
You are probably thinking 'Wow! I will get 1,000:1 leverage and make millions from $100 trades'. Sadly it does not work that way. Let's do some math soldier:
We have already figured out that each GBP/USD pip is worth $0.000099
So let's say you invest 1 mini lot ($100) leverage at 100:1.
$100 x 100 = $10,000 leveraged dollars
This means you are trading $10,000 so
$10,000 x $0.000099 = $0.99 per pip
This means that it will take you about 100 pips to double your $100 or 100 negative pips to lose your $100.
$0.99 x 100 pips = $99
Let's take the same trade leveraged at 1,000:1
$100 x 1,000 = $100,000 leveraged dollars
$100,000 x $0.00009999 = $9.99 per pip
This means that it will take you about 10 pips to double your $100 or 10 negative pips to lose your $100.
See the difference? 10 pips are not much so the higher you are leveraged the less room you have to breath.
1,000:1 leverage does not exist as far as I know. I just used it as an extreme example. The highest I have seen is 400:1, and that is still too high! Anything above 100:1 is too much and anything below on a small account is very limiting. In my opinion the best leverage to have is 100:1.
What is leverage?
I am trying to think of the simplest way to explain a margin call, but there really is none. So I will just throw it all out there and hope you can make sense of it.
Useable margin basically means the amount of money you have in your account available to take a trade with. So let's say you have $10,000 in your account. With no open trades, your useable margin is $10,000. Now let's say you take a trade on GBP/USD with one standard lot ($1,000) your usable margin becomes $9,000. For simplicity's sake let's say each pip is worth exactly $10, this will mean if you lose 900 pips you will reach the end of your useable margin. At this point your broker closes the trade and you are left with the remaining $1000.
Now that is an unlikely situation. No trader in their right mind will let a position move 900 pips against them. A more common occurrence would be trading a standard $1,000 lot on a $3,000 account, as soon as the position is open you have $2,000 useable margin. If the trade goes 200 pips against you then you will get a margin call.
There are pairs like GBP/AUD for example that are worth more per pip. Some pairs are worth $2 so obviously trading those pairs you would only need to lose 100 pips trading a full lot to lose $2,000.
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