In Forex, exchange rate changes are measured in pips. In order for one to see any signifcant profit or loss, you’ll have to trade large amounts of currency. As you already know, most brokers will allow you to trade in lots. These are the most common lot sizes:
- 1 Standard lot equals 100,000 units
- 1 Mini lot equals 10,000 units
- 1 Micro lot equals 1,000 units
- 1 Nano lot equals 100 units
Now you might wonder how you can afford to trade such large lots to be able to make
decent profit in Forex. This is where your broker comes in and basically “lends” you the money you need to make such large currency trades. All that is required is that you deposit a small amount of money.
That is how trading on leverage works. The amount of leverage you have will usually depend on your broker and how much money you have in your account.
If the leverage is 100:1 ( which means you need to deposit 1% of the lot size you want to buy), and you want to open a $100,000 position, you will only need a deposit of $1,000 for the trade. This is known as your margin, which will be returned to you when you close the trade.
Calculating Profit and Loss
The current bid/ask price for EUR/USD is 1.2320/23, meaning you can buy 1 euro with 1.2323 US dollars or sell 1 euro for 1.2320 US dollars.
Suppose you decide that the Euro is undervalued against the US dollar. To go about this strategy, you would buy Euros and then wait for the exchange rate to rise.
So you make the trade: to buy 100,000 euros you pay 123,230 dollars (100,000 x 1.2323). Remember at 1% margin, your initial margin deposit would be $1,232 for this trade.
As you expected, Euro strengthens to 1.2395/98. Now, to realize your profits, you sell 100,000 euros at the current rate of 1.2395, and receive $123,950.
You bought 100k Euros at 1.2323, paying $123,230. You sold 100k Euros at 1.2395, receiving $123,950. That is a difference of 72 pips, or ($123,950 – $123,230 = $720).
Total profit = US $720