The most traded currencies are the USD (United States), the EUR (Euro Zone), and the JPY (Japan). Even though FOREX trading is becoming more and more popular among retail traders, some concepts are still unfamiliar to many people. Words like leverage, margin trading, and PIP are essential to fully understand this market and trade it.
What are they mean?
This article will explain these concepts in detail.
Using The FOREX Market To Invest In Currencies
When you invest in the Foreign Exchange market, also known as the FOREX or the FX market, you buy and sell currencies. Of course, you are not really buying and selling currencies. You speculate on the value of a currency against another one.
Is a currency strengthening/weakening against another one?
The direction of your position depends on your preferred scenario: long – buying positions, and short – selling positions.
If you think that the EUR will strengthen against the USD, you would buy the EUR/USD currency pair. In the following chart, you would pick this scenario after the bullish gap that you can see on the right part within the green circle. Prices crossed upward over the simple moving average (SMA) of the Bollinger Bands and tested once more the moving average, before starting a strong bullish movement.
Conversely, if you think that the EUR will weaken against the USD, you would short-sell the pair. You can also go short on the pair if you think that the USD will strengthen against the EUR. You would pick this scenario when prices started to weaken in the left part of the chart. With strong volatility (as shown with the upper shadow of the candle in the rectangle), prices easily crossed downward under the SMA.
Afterwards, prices kept moving downward for at least another week.
When you buy the EUR/USD pair, you buy the EUR while automatically selling the USD. This is a simple concept to understand, as currencies always trade in pairs.
You can also sometimes trade the value of a currency against a basket of currencies, such as the dollar index. This index tracks the evolution of the American dollar against the EUR, the GBP (United Kingdom), the JPY, the CAD (Canada), the SEK (Sweden) and CHF (Switzerland).
When prices increase, it means that the USD is strengthening against its main counterparts (as you can see on the green channel on the following chart) and vice-versa (red channel).
What Is A PIP In The FOREX Market?
When a currency moves (upward or downward) against another, the pair gains or loses “PIPs”. A PIP or Percentage In Point is the smallest price change. Let’s say that the EUR/USD moves from $1.1868 to $1.1869, it means that the pair rose by 0.001 $ in value, or 1 PIP.
A PIP is usually the last decimal of a quotation – the 4th decimal with most currency pairs. However, with all the pairs involving the Japanese Yen, or JPY, the PIP is the 2nd decimal of the quotation.
Why Using PIP?
Being able to calculate the value of a PIP can help you compute your profits or losses. It’s also a great tool to better manage your trading risk. Of course, it all depends on your trading position size as well, as well as the currency. As exchange rates are different from one another, the value of 1 PIP cannot be the same for all currencies.
On the FOREX market, positions (or quantities) are called lots. The standard lot size is 100,000 units, but most brokers offer different kinds of lots, such as mini lots of 10,000 units, micro lots of 1,000 units, and nano lot of 100 units. Let’s have a look at an example with a mini lot on the EUR/USD that you buy at $1.1860.
How To Compute The Value Of A PIP?
Let’s say that the market goes in your direction and the pair reached $1.1865. The difference between the opening price and the closing price is then equal to 5 PIPs (1.1860-1.1865).
To find out the value of 1 PIP for this currency pair, you need to multiply 10,000 (the notional amount of the trade) by the decimal form of 1 PIP, divided by the exchange rate. The calculation of the value of 1 PIP for this example would be: 10,000*(0.0001/1.1860) = EUR 0.84. If you close your position now, you will profit from an increase of 5 PIPs, so your profit will be EUR 4.2 (0.84*5).
The most important thing to figure out is the value of a PIP in your account currency
To do so, you only need to multiply or divide the value of the PIP you found by the exchange rate. If your account is in US dollars, then you need to know the value of a PIP in USD. To find the value of 1 PIP in USD with our previous example, you need to do the following: 0.84 * 1.1860 = $0.9962. You can round up at $1 per PIP.
Leverage, Or How Small Investors Can Invest So Much
With standard and mini lots, you might wonder how it is possible that so many retail investors can afford to trade. How can they make money from the FX market with such a small initial trading amount? It’s easy: it’s all about leverage and margin trading. Let’s explain:
Think about your broker as a bank: it lends you funds, so then you can increase your market exposure. If you want to open a position with borrowed funds, your broker will ask you to set aside a portion of this position. This amount is like collateral and is called margin.
Leverage is like a loan offered by the broker that allows you to trade larger trading positions. For a position trader or a swing trader, it’s important to understand that borrowed money has a cost, and thus an impact on your overall results. As a swing trader, you will follow a trend, which can last a few days, weeks or more.
As a consequence, you will use borrowed funds for that time, which you will have to pay for. If you are a day trader or a scalper, the interest that you will pay on the loan won’t affect your trading performances, as you will close all your trading positions before the end of each trading day.
If a trader has 1,000$ in his account and available leverage of 10:1, it means that his trade size could be 10 times higher than his equity, or $10,000. Let’s say that the EUR/USD moves up 100 PIPs. With an investment of $1,000, you could have made a profit of $10 with a PIP value of about $1.
However, with leverage of 100:1, your profits could be as high as $1,000 (100*10), as every $1 you invest will be worth $100. With a 100:1 leverage, you could potentially open a $100,000 trading position with a $1,000 account.
Margin Trading And Leverage Are Risky
The main advantage of leverage is that it amplifies your profits. On the other hand, it also increases your potential losses. As a consequence, the more leverage you use, the more risk you take. Leverage and margin trading are thus risky and you need to apply sound money management rules.
Always use a stop-loss and take-profit orders before opening a position to protect your trading capital. When you spot a trading opportunity, determine first the potential profit you want to achieve and the loss you are willing to accept.
This information creates the risk/reward ratio. Most of the time, the minimum ratio is about 1:2. A more careful approach would be to use a 1:3 risk/reward ratio. As you can see on the chart below, this ratio will help you determine your stop-loss and profit levels depending on your entry level.
The Impact Of Risk
Depending on the inherent risks (such as the global geopolitical situation), your broker might change its margin requirement and leverage level. This can affect your trading performance, so it’s important to stay up-to-date about changes in trading conditions from your broker.
Volatile Times Requires More Funds
Margin calls can happen during volatile times, when prices evolve rapidly in one direction. If you are wrong and there isn’t enough money in your account to cover your losses as well as the margin, you might experience a margin call. It means that your equity falls below the broker regulatory requirements about margin debt.
At that point, your broker will issue a margin call and asks you to fund your account because there aren’t enough funds to cover your losses. Your positions can also be automatically closed if you do not meet quickly the requirements. It’s important to keep a cushion just in case something bad happens, so do not invest all your money in a single position.