Let’s do a bit a of maths. Probably you heard about ‘pips’ and ‘lots’, but here we’ll explain how these are calculated.
You must be careful about knowing this, because this is necessary knowledge for all forex traders. Don’t even think about trading until you feel comfortable with the pip values and calculation of profits and losses.
What’s a pip ?
The smallest modification of the forex contracts values is called a pip, and a pip is one unit on the last decimal of the price. For instance, a movement on EUR/USD from 1.3353 to 1.3354, is a pip. Profits and losses are measured in pips, and they are considered in the counter currency (the second currency from the symbol).
Let’s open a small parenthesis here: in the futures world, though the pip can be defined the same, prices advance in terms of tick size, that is, the minimum modification of the price is 0.25 instead of 0.01.
Let’s return to forex, and we take the quote of the USD/JPY at 107.80. Notice that for this currency pair it’s just two decimals, whether the large majority have four; however, for the so-called “5 decimal brokers”, currency pairs have 5-decimal quotes, while the ones denominated in JPY have 3 decimals.
The concept of pip value has sense only if we calculate the pip in the currency that the account is denominated to.
For instance if we want to calculate the pip value on USD/JPY, then the pip is in JPY.
If we have our account denominated in USD, then
Pip value = JPY/USD, or, easier, (1/ USD/JPY)
If we have our account denominated in EUR, then
Pip value = JPY/EUR, or, easier, (1 / EUR/JPY) . If we don’t have EUR/JPY on our disposal, then we use the equivalent equation:
EUR/JPY = EUR/USD x USD/JPY
In this case, we have an account denominated in USD, and the pip, of 1 JPY, at the abstract mode, values:
1 / 107.8 = 0.00927 USD
But what if we’d have EUR/USD ? In this case the result is straight in dollars. How would it be if we’d have the account denominated in EUR ? Then the pip value would be USD/EUR or 1 / EUR/USD.
Let’s say we buy EUR/USD at 1.3200 and we sell at 1.3230. In this case we won 30 pips. If the currency of our account is USD, then the 30 pips stay the same. But we’d have the account denominated in EUR, then
1 pip ~ 1/1.32 = 0.75(75) EUR and the 30 pips in dollars would value just 30 x 0.75(75) meaning 22.724 EUR.
Pip value, trade results and leverage
In previous cases, we supposed trades in which we use exactly the capital we have similarly to exchanging our money over the counter.
Let’s say that someone has euro in a bank account. If today EUR/USD is 1.3000 and tomorrow EUR/USD is 1.3200, it won 200 pips, or 0.02 dollars for each euro in the account. It didn’t win, anything at all in euro, as the amount from the account didn’t change. This is also a way to defend against inflation : change your money in another currency. But this wouldn’t be a way to profit, but to merely slow down the capital erosion, cause you don’t earn anything versus the currency in which you exchange.
And this rule is valid for every financial investment. There is never a win in the base instrument. For instance: the stock investor doesn’t win more stocks from the growth of the stock price, the gold investor doesn’t make more gold from the growth of the gold price, and the investor in currencies doesn’t make more in the currency in which he invested. But the profit is felt because it’s compared, in the margin trading accounts, such as forex or stocks, to the equity.
Therefore the abstract value of the pip is not also a useful value. It’s totally different in forex, when you’re working on margin, on borrowed money, that has to be payed off.
And here comes into discussion the trade value. We’ll calculate the same pip value, in two cases: for a trade of 1000 euro, and for a trade for 10000 euro.
We go back to the EUR/USD example.
If the trade is 1000 euro, the pip value is : 0.0001 x 1000 = 0.1 USD.
Therefore 30 pips = 3 USD.
If the trade is 10000 euro, the pip value is : 0.0001 x 10000 = 1 USD.
Therefore 30 pips = 30 USD
So, one thing is to win/lose 10 cents per pip, and totally different is to win/lose 1 dollar per pip.
Forex trades are trades in margin. The equity is just a fraction out of the trade values. The difference between the trade value and margin is actually a credit given by the broker.
Multiplying the results of the trades following the usage of credit is called leverage effect. Also known as mace effect, due to its destructive effects.
For instance, for the same amount of 300 euro, at a maximum admissible leverage of 1:200, there can be controlled amounts up to 60000 euro.
In a trade on EUR/USD,
10 lost pips at 6000 euro are just 6 dollars (10 x 0.0001 x 6000). The loss is quite nothing (2% from the capital of 300 euro).
10 lost pips at 60000 euro are 60 dollars (10 x 0.0001 x 60000). The loss is substantial (20% from the capital of 300 euro).
This is the power of the mace effect! Don’t go for deceptive commercials praising the leverage!
What’s a lot ?
The spot forex market is traded in lots. The size of a standard lot is 100,000 units in the base currency, but some brokers may implement standard sizes of 10,000 units . The great majority of brokers offer MetaTrader platform, that can trade even 0.1 lots or even 0.01 lots (depending on what the broker allows).
Remember, the standard value is in units per the base currency. If this is 100,000 , then it’s 100,000 EUR for EUR/USD, 100,000 AUD for AUD/USD or AUD/JPY etc.
From leverage to margin
Let’s first distinguish between the leverage of the account and the effective leverage.
In corporate finance, leverage is calculated as ratio between debt and equity.
Let’s move it to forex. In forex, leverage is calculated as ratio between the value of the current trades and equity.
We have a trade of 20000 euro, and just 300 euro in the account.
Therefore we borrowed from the broker 19,700 euro.
The effective leverage, calculated with the corporate finance formula, is 19700/300 = 65.66 meaning that we have a debt 65.66 times higher than the equity.
Recalculating with the forex formula, we have a leverage of 20000/300 so 66.66 . So the aggregate values of our trades (in this case, only one).
In this case the difference between the two values can’t be felt, but if you would trade 10,000 euro while having 10,000 euro in the account, the debt to the broker would be 0, and the leverage should be 0, instead of 1.
On another hand, when we opened the account, it was specified 400 as leverage. That’s the leverage of the account, or the maximum of the effective leverage. The broker wouldn’t allow trades of more than 300 x 400 = 120,000 euro.
The margin is the correlative of the leverage, the other face of the coin. It can be interpreted as “sequester”.
Because the maximum leverage is constant, the margin, or the deposit to sustain the trade is also constant, and that is trade value divided to account leverage.
The entire equity that you have is “sable margin”. Usable, but not also required.
So, at your trade of 20000 euro, the margin is 20000/400 = 50 euro. Just 50 euro are “sequestered” to sustain this trade.
WARNING! THE MARGIN IS NOT A WAY TO ASSESS THE RISK! In the trade above, the margin remains 50 euro no matter if you have in your account 300 sau 30000 euro, so therefore is indifferent towards the pip value in your trade!
From leverage to margin
Essentially, Margin Call is just a warning, and Stop Out is a violent closure of all trades.
The total of the used margin by all your trades launched in the market (not pending, that will become filled at some moment), form the required margin, or the “sequestered” amount from your equity.
Margin Call is just a warning. That’s why is a “call”. A call of horror, that the client receives from the broker when his losses are substantial.
When the equity goes below the “Margin call level”, this warning takes place.
When a broker says “Margin level = 30% and Stop Out level = 20%”,
It means that as soon as the as the equity attains 30% of the required margin (those 50 euros calculated), you get the Margin Call warning.
But when the equity attains 20% of the required margin, then the broker will close your trades, starting with the most profitable.
When the broker says “Margin Call level = 100%”, then margin call and stop out happen at the same time. As soon as the equity touches the required margin (50 euro in our case), the broker will start closing the trades.
That’s why it is vital that you know what are your broker policies regarding the margin and stop out.
If you adventure outside the instruments that are strictly forex, such as stocks or commodities, you have to know that those have margin requirements higher overnight and over weekend. Therefore a position that has no problem in daytime can be stopped out at the end of the session!
In conclusion, pick accounts that allow you a higher leverage, but USE ONLY AS MUCH LEVERAGE AS NEEDED, BECAUSE THE PIP VALUE MAKES THE PROFIT AND THE LOSS!