Forex Basics: Spread, Lot size, Swap, Margin and Leverage

There are some basic terminology that a Forex trader must know in order to be informed in the world of Forex trading.  Throughout this blog I will introduce you to some of those terms.  As your Forex knowledge advances, you will be able to follow along and use these terms with no issues or confusion.  Let these posts serve as a reference guide for you.  This post will in go depth as to what is meant by the Spread, the Lot size, Swap, the Margin and Leverage when you are trading in the Forex market.

What is the Spread in Forex?

One of the key terms a Forex trader needs to know about is role of the spread in regard to trading.

The easiest way to think about the spread is to consider it as the fee the broker charges to trade on their platform.

The middleman has to get their cut somehow right? Spread is based on supply and demand!

You can calculate the spread by calculating the difference between the buy and the sell price of a currency.  When you are doing the research to find a good broker one of the key factors you should consider is how low (high) (tight) is the spread for that broker.  If you are familiar with other trading markets then the concept of the spread shouldn’t be a new to you. Some brokers charge a fixed spread, so check the details of the broker you choose before depositing funds into your trading account.

The spread is important because you need to know how much money will be deducted from your overall capital each time to enter a trade.  Knowing the spread basic information in your money management strategy.

Keep in mind: There are brokers that use the market maker and ECN system which allows them to charge a very tight spread but these brokers also usually charge a commission for every transaction executed.

Some important info about spreads

  • Spread volatility is closely related to the market volatility.
  • Most major and cross pairs have a typical spread of 1 pip or less
  • Look for brokers that have a low spread volume
  • Exotic pairs will have much higher and more sporadic spreads
  • Being aware of spread is part of risk management
  • Spreads tends to be wider at market open and during high level reports
  • To calculate the spread just take the difference between the ask and the bid prices

Forex traders must understand how significant it is to consider the spread is when choosing a broker. The difference of one pip on one broker's platform versus another broker’s spread volume on their platform might be the difference between a profitable Forex trader and an unprofitable trader.

Side note: A pip is defined as the fourth digit after the decimal in a currency pair.

 What is Lot size in Forex?

Forex pairs are traded in “lots”.  Lots are referred to as the contracted number of units that a pair sells for.  A standard lot in Forex trading is 100,000 units.  The wonderful thing about Forex is that we have the option to trade in not only a standard lot but at a much lower lot rate by way of mini lots, micro lots and nano lots.  The unit measure of a mini lot is 10,000 units, the unit measure of a micro lot is 1,000 units and the unit measure of a nano lot is 100 units.

Because price fluctuations in Forex are minute the price change usually is only seen at the pip or pipette level.  So at .0001 or .00001 is where you will see the price change.  Now take the numbers given above for your lot sizes and you can calculate how much profit (or loss) you will earn per pip.

Example:

Standard lot trading—100,000*.0001= $10.00 per pip so a gain of 10 pips will be a gain of $100.00

Mini lot trading—10,000*.0001=$1.00 per pip so a gain of 10 pips will be $10.00

Micro lot trading—1,000*.0001=$0.10 per  pip so a gain of 10 pips will be $1.00

Nano lot trading---100*.0001=$0.01 per pip so a gain of 10 pips will be $0.10

(examples are based on USD pairs)

Remember: the same is true on the loss of a trade so be aware of your lot size and pip value before you enter a trade.

Rookie Mistake: (any trader really) When using the one-click trading function, double check your lot value, as the platform typically defaults to a standard lot size and if your account is smaller you can blow your account aka margin call in one trade!

Why is Lot size Important?

It is important to know the lot size of your trade to stick with your risk management rules.  As a rule of thumb a Forex trader should only risk 1-2% of capital per trade.

Example: A Trader has $1,000.00 of capital at 1% risk she can risk $10.00 per trade… So at this point she can decide on her stop loss and her take profit according to her risk tolerance.  $1000*.01=$10  so the better choice for this trade would be to trade using a nano lot size of $0.10 and risk up to 100 pips. Doing this will ensure the trade doesn’t lose no more than $10.00  if her trade goes against her and still live to trade another day!

What is a Swap in Forex?

The swap is a fee that is charged at the end of a trading day.  Basically if you are in a trade overnight (GMT time) you will be assessed a fee.  In some instances, the fee will be a negative charge against your capital in other instances it would be a positive fee added to your capital.  The fee is essentially the interest rate of the currency you are trading and is determined based on your position; long or short.

Overnight long positions for a trade that ends in a gain will yield a positive swap

Overnight short positions for a trade will yield a negative swap.

What is Margin in Forex?

Think of Margin as your investment amount…..your initial capital.  You will hear your trading account deposits referred to as your account margin.  Each broker has a minimum initial account margin requirement, so check with your broker to determine if your planned initial deposit meets your broker’s minimum amount requirements.

What is Leverage in Forex?

Leverage…..Ahh! the gift and the curse of Forex.  Leverage is the amount your broker basically loans to you, the trader, to buy and sell currencies on their platform.  One of the reasons why Forex is so attractive as a trading entity is due to the fact that the leverage amounts are typically a lot higher than other commodity markets.   This is because of the minute movements in price action, if leverage wasn’t involved Forex as a trading medium would not be profitable.  Typical leverage amounts are 50:1, 100:1, 200:1 and can go as high as 500:1 or more.  Leverage allows the trader to have more buying power on each trade.

Example: a 100:1 leverage amount will give a $1,000.00 deposit the power to trade as a $100,000.00 deposit.  So when you make a deposit of $1000.00 using a 100:1 leverage you in essence have $100,000.00 in trading capital to use for trading and the $1000.00 that you initially deposited into your trading account is your collateral for the use of the leveraged amount.

Carefully review your broker’s platform for specific details regarding leverage amounts, initial margin requirements, and other regulations.

Tips for general Forex trading…….

To become a successful Forex trader please consider:

  • One of the most basic lessons in Forex trading is learning what the spread is and how it is used in trading. Always be aware of spreads. Spreads can widen at any time so be cautious of the spread amount before you enter a trade.  Expect the spread to widen before, during, and after major report releases, during high volatility, and at market open.
  • Forex is traded according to contracted units or Lots.  Lot sizes are as follows:
    • standard 100,000 units
    • mini 10,000 unit
    • micro 1,000 units
    • nano 100 units
  • Swaps are interest fees paid or charged to your Forex trading account once a position is helped overnight.
  • Margin is you investment in the currency market deposited into your broker’s trading platform and is used to determine your risk amount.  The smaller your margin account is the smaller your lot size should be in order to sustain a loss or few and still maintain to trade another day.
  • Leverage is absolutely a gem of forex but have to be used responsibility. Leverage gives you the ability to trade with more buying power on a modest initial investment.

 

Be the first to comment

Leave a Reply

Your email address will not be published.


*