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5 Terms Every Forex Trader Should Know
Term 1) Margin / Leverage
Term 2) PIP Value
Term 3) Spread
Term 4) Base / Counter Currency
Term 5) Lot Size
Term 1: Margin/ Leverage
Margin and leverage are one and the same to allow traders to be able to manage higher value positions in their account in comparison to the cash held. Margin can be described as the deposit needed to open a trade. An example may be 1% margin required which means that $1000 is needed as a deposit for a $100,000 trade.
Leverage on the other hand is the amount of times you can gear up. In simple terms if the leverage is 100:1 then for every $1 in your trading account, a trader can buy or sell $100.
Think of margin and leverage as the same concept as buying a house. A bank may usually lend part of the money required to purchase. A homeowner may only need to put down a 15-25% deposit to buy a house and get a loan for the remaining balance. This concept is the same in Forex however interest is not charged on the remaining funding.
Margin and leverage while potentially boosting profits, and also amplify losses and needs to be managed correctly.
Term 2: Pip Cost
We have already covered ‘What is a pip’ in one of our previous articles. The cost of this pip is essential when calculating your profit and loss from each trade. The easiest way to calculate the pip cost off the top of your head is to calculate the pip cost or value in the counter currency. The counter currency is the second listed currency in the currency pair. Therefore, in the EUR/USD pair the counter currency is the USD.
Now that you understand what the counter currency is it is relatively easy to calculate the pip cost. If a trader buys 100k of a currency, then each pip is valued at $10. If a trader buys 300k the pip cost increases to $30 per pip. A 1k trade would equal $0.10 per pip and so on and so forth. The final calculation would be that if the pip cost needs converting into the currency of your account. For example a GBP account would require the USD calculation being converted back into GBP. Luckily on most trading platforms, the pip is cost is calculated automatically. In any event it is very useful for traders to be able to calculate the pip cost in their heads!
Term 3: Spread
The spread very simply is the difference between the buy price (the ask) and the sell price (the bid). It is important to know what the spread is as this is the transaction cost when a trader places a trade. If the spread is narrower or tighter, this means that there is more liquidity or more market participants which means that the cost of trading is lower. The most active / highest volume currency pair is the EUR/USD and the spread on this currency pair can be as little as zero! On average the institutional spread tends to average around 0.3 or three-tenths of a pip. On a 100k EUR/USD trade the cost would be around $3 (see pip cost above)
Whenever a trader places a trade, they will always pay the spread meaning the buy price will be higher than the sell price and the sell price lower than the buy price. Therefore when a buy trade is entered at the ask price the trade will always start off slightly negative as the exit price now refers to the bid which is the sell price. This may seem slightly confusing however most trading platforms will show you the live spread embedded in the platform. Also please see our other articles on the spread which explain more!
Term 4: Base / Counter Currency
The base and counter currency is a relatively easy one to get your head around. For simplicity, the first listed currency in the pair is always the currency that you are taking a position on. Lets again use the EUR/USD currency pair as an example. In this case the Euro is the base currency and US Dollar is the counter currency.
When a trader buys or sells any currency pair, they are always taking a position on the base currency. So if a EUR/USD sell position is entered, essentially the trader is selling Euros and buying US Dollars, taking a position or bet that Euros will decrease in value against US Dollars that increase in value.
In the EUR/USD pair the counter currency is the USD which is important when determining the pip cost. As mentioned previously a 100k buy position on the EUR/USD means that each pip is calculated in USD at $10 per pip. In a 100k sell EUR/GBP trade each pip is worth £10 GBP as the counter currency in this case is the GBP.
Term 5: Lot size
Knowing what lot size you are trading ties in with all the other important terminology when trading the forex market. Many traders trade on the MetaTrader platform and on this platform a lot size can be drilled down into three main ones:
- Standard lot = 100k or 100,000 of the base currency. On MetaTrader this lot size is entered as 1.0 which is the equivalent of a standard lot
- Mini lot = 10k or 10,000 of the base currency. On MetaTrader this lot size is entered as 0.1 which is the equivalent of a mini lot
- Micro lot = 1k or 1,000 of the base currency. On MetaTrader this lot size is entered as 0.01 which is the equivalent of a micro lot
When trading EUR/USD the lot size determines the pip cost within the counter currency. With a standard lot the pip cost is $10 per pip, a mini lot is $1 per pip and a micro lot is $0.10 cents a pip. Lot size, leverage, margin and pip cost all tie in together and are all important terms to understand when trading Forex!