Forex Lots & Contracts, Leverage and Margin, Spread, Bid and Ask Price
Lots and Contracts
Forex is traded using Standard Lots. One standard lot is equal to 100,000 units of currency. One standard lot is also known as a one contract.
The Forex Lot or Contract is the size of the amount of currency that is to be bought or sold in the online exchange market by an FX trader.
The Standard Lot which is equal to $100,000 Dollars worth of currency is not traded physically, but this $100,000 Dollar amount is represented by a contract.
The two terms, that is 1 Standard Lot and 1 Contract can be used interchangeably, because both of them refer to the same thing - $100,000 Dollars of Transaction in the FX Market.
Why Trade Units of Currencies of $100,000
The reason why such large contracts are used is so as to increase the value of a pip (profit).
The Currency Price moves are measured in Pips - Price Interest Points
100 Pips Make 1 Cent, therefore the price movements are calculated using very small price movements.
EURUSD will be quoted as 1.3452
The last decimal is the PIP (4th Decimal Place)
From 2010, a fraction of a pip movement was introduced and this is now referred to as fractional pips or pipettes.
EURUSD will be quoted as 1.34520
The last decimal is the PIPETTE (5th Decimal Place)
To answer the question why currencies are traded in lots of $100, 000 Units of a currency, we shall use the following example to explain:
Most currencies in the FX market will not even move more than 1 Cents a Day, 1 Cent is equal to 100 Pips, and the most common price moves are between 40 pips and 80 Pips.
- For one foreign exchange contract (standard lot) of $100,000
Value of 1 pip = 0.0001 USD
If one unit is used of 1 Euro then Value of 1 pip = 0.0001 USD
If 100,000 units (1 Forex contract) of Euros are used then value of 1 pip = 100,000*0.0001= 10 USD
NB: 100,000 units of Euro are used but the profit is calculated in USD, the quote currency and because the Exchange Trade is EURUSD.
Therefore you an see that if you are trading with only 1 Euro your profit per 1 PIP price movement would have been 0.0001 USD, not even equal to 1 Cent, But when you trade with a standard lot of 100,000 Unit then profit is equal to $10 dollars per 1 PIP.
This is why Forex is traded using 100, 000 Units of Currency Contracts/Lots.
But How Can any Trader afford $100,000 to Invest With?
That is a very good question, the answer is LEVERAGE and MARGIN
You don't need $100,000 Dollars to trade, with leverage and margin you only need $1,000 dollars to transact a contract, but how?
We shall explain using the example below:
In Forex, a small deposit can control a much larger transaction this is called Leveraging, which gives the traders the ability to make nice profits, and at the same time keep risk capital to a minimum. The trader will transact on borrowed capital, having $1,000 dollars one can borrow the rest using a leverage option such as 100:1 - meaning that one borrows 100 dollars for every 1 dollar they have, therefore in total they will control a total of $100,000 dollars - this is how leverage works.
Leverage is expressed in the form of a ratio, for Example 100:1, means the broker with give a trader $100 Dollars for every 1 dollar that the trader has.
Margin is the amount of money required by your broker so as to allow you to continue trading with the leveraged amount. Foreign Exchange Margin is the amount you deposit so as to open an account with. If you deposit $1,000 then that is your margin.
With leverage it is possible for retail investors to trade the Foreign exchange market. Leverage of 100:1 means that for every dollar you deposit, the broker will give you 100 dollars. This also means that in converse the broker requires you to maintain a margin of $1 Dollar for every $100 Dollars that they give you so as to let you continue controlling the borrowed amount of capital that they have given you for trading.
Forex Margin Trading Example:
If you deposit $1000, and the broker gives you leverage of 100:1 then it means you now have $1,000*(100) = $100,000 Dollars that you can trade with.
Because the total amount you control is $100,000 and your money is $1,000 which is 1%, this will mean your margin requirement is 1%.
A broker can tell you that our margin accounts require 1 % which means their leveler is 100:1, if they tells you their accounts require 2% margin it means their leverage is 50:1 (calculation: 1 is 2 % of 50).
Therefore, with Leverage and Margin as shown above traders are not required to deposit all the cash for the whole position they are going to trade. The account they open will therefore be referred to as a Margin Account meaning they are trading on margin - the funds in their account is the margin for the leverage they are using for trading.
The spread is the difference between the price which you buy and the price that the broker is offering to sell.
Spread can also be defined as the difference between the Bid Price and the Ask Price, this Bid and Ask price are shown on the example below and the spread is also calculated as the difference between these 2 price points.
Example of Spreads on MT4 Platform
EURUSD - Bid Ask Spread Calculation of 1.5 Pips
Example of How to Calculate Spread:
If The Bid Ask of EURUSD is 1.2914/1.2917
The Spread is 1.2917-1.2914= 3 pips
These 3 pips is profit for the broker. If you were to buy EURUSD you would buy at 1.2917. If you wanted to sell back the EURUSD you have just bought, the broker will buy from you at 1.2914, i.e. 3 pips less than the price you bought, the broker makes profit this way. The lowest spreads charged is about 2 pips for major currency pairs. It is best to open an account where the spreads charged are low so that you can reduce your transaction costs when buying and selling.
Update: From 2010, there was introduction of fractional pips, with fractional pips brokers also argued that they could now offer lower spreads.
For Example in the above spread illustrated on the MetaTrader 4 Platform Bid Ask Quotes the spread is:
Spread is 1.33790-1.33750= 1.5 Pips
Most brokers now use the fractional pips, 5 Decimal Place Quotes so as to offer traders lower spreads, commonly referred to as "tight spreads", for example 1.8 Pips Spread instead of fixed 2 Pips spreads.
Examples of Average Spreads (Major Pairs) in The Foreign Exchange Market
- EURUSD - 2.0 Pips Spread
- USDJPY - 2.0 Pips Spread
- GBPUSD - 3.2 Pips Spread
- USDCHF - 3.2 Pips Spread
Bid is the price at which you sell
Ask is the price at which you buy
If the quote for EURUSD is 1.29140/1.29170
Bid Price =1.29140
Ask Price =1.29170
Example Of Bid Ask on MetaTrader 4 Platform
Bid Ask Prices of Various Foreign Exchange Currencies on MT4 Platform
Mini Lots and Micro Lots
As a note, there is also the fraction of 1 Lot, these fractions of the standard lot are provided by brokers so as to make Forex more affordable to traders with minimum capital required being as as little as $100 dollars.
The Fraction of a standard lot are called Mini Lot which is 1/10 of a standard lot and Micro Lot which is 1/100 of a Standard Lot
Mini Lot = $10, 000 Units of Currency
Micro Lot = $1, 000 Units of Currency
These mini lots were introduced to make the FX Market more accessible to the retail FX investor as well as attract more and more retail investors. Maybe this is why Forex has become very popular, even with as little as $100 dollars anyone can enter this market.