Forex Lots and Contracts - Explain Lot Size, Leverage & Margin and Spread - Bid and Ask Price
Lots and Contracts Explained - Lot Size: Standard, Mini and Micro Lot
Forex is traded using Standard Lots. Lot Size Forex - One standard forex lot is equal to 100,000 units of currency. One standard lot is also known as a one forex 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 a trader.
Lot Size Forex - The Standard Forex 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 FX Trade Transaction in the Market.
Why Trade Forex in Units of Currencies of $100,000
The reason why such large forex contracts are used in trading is so as to increase the value of a pip (profit value).
The Currency Price moves are measured in Forex Pips. PIP - Price Interest Points
100 Forex Pips Make 1 Cent, therefore the price movements are calculated using very small price movements.
EURUSD currency pair will be quoted as 1.3452
The last decimal is the PIP (4th Decimal Place)
In trading, a fraction of a pip movement was introduced by brokers and this is now referred to as fractional pips or pipettes.
EURUSD currency pair will be quoted as 1.34520
The last decimal in the forex currency quote is the PIPETTE (5th Decimal Place)
To answer the question why forex currencies are traded in lots of $100, 000 Units of a currency, we shall use the following example to explain:
Most currencies in the forex market will not even move more than 1 Cents a Day, 1 Cent is equal to 100 Forex Pips, and the most common price moves in trading are between 40 pips and 80 Pips.
Example:
- For one forex 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 can 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 forex trade with a standard lot of 100,000 Units of currency then the 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 Forex Trader afford $100,000 to Invest With?
That is a very good question, the answer is Forex LEVERAGE and MARGIN
You don't need $100,000 Dollars to trade forex, with leverage and margin you only need $1,000 dollars to transact a forex contract, but how?
We shall explain using the trading 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 a trader can borrow the rest using a leverage option such as 100:1 - meaning that the trader borrows 100 dollars for every 1 dollar they have, therefore in total they will control a total of $100,000 dollars after using leverage of 100:1 - this is how leverage works.
Forex Leverage is expressed in the form of a ratio, for Example leverage 100:1, means the broker will give a trader $100 Dollars for every 1 dollar which the trader has in their forex account.
Forex Margin is the amount of money required by your broker so as to allow you to continue trading forex with the leveraged amount. Forex Margin is the amount you deposit so as to open a forex account with. If you deposit $1,000 in your account - then that is your forex margin.
With leverage it is possible for retail investors and retail traders to trade the FX trading 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 forex trading.
Forex Margin Trading Example:
If you deposit $1000 in your trading account, 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 account requires 1 % margin - which means their leverage is 100:1, if the broker tells you their margin account require 2 % margin it means their forex leverage is 50:1 (leverage 50:1 - calculation: 1 is 2 % of 50 when using 50:1 forex leverage ratio).
Therefore, with Forex Leverage & Margin as shown above traders are not required to deposit all the cash for the whole trade position they are going to trade. The trading account they open will therefore be referred to as a Forex Margin Account meaning they are trading on margin - the funds in their account is the margin for the leverage they are using for trading.
Spread - Forex Spreads - What is Spread?
The forex spread is the difference between the price which you buy and the price that the broker is offering to sell.
What is Spread? - Forex Spread can also be defined as the difference between the Bid Price and the Ask Price, this forex Bid price and Ask price are shown on the example below and the forex spread is also calculated as the difference between these 2 price points.
Example of Forex Spreads on MT4 - What is Spread?
EURUSD Currency Pair - Bid Ask Spread Calculation of 1.5 Pips
Example of How to Calculate Forex Spread:
If The Bid Ask Quote of EURUSD is 1.2914/1.2917
The Forex 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 low spreads charged is about 2 pips for major currency pairs.
Update: there was introduction of fractional pips, with fractional pips brokers also argued that they could now offer lower spreads - spread such as 1.8 pips or 1.7 pips instead of 2 pips forex spreads.
For Example in the above spread illustrated on the MT4 Platform Bid Ask Quotes the spread is:
1.33790/1.33750
Spread is 1.33790-1.33750= 1.5 Pips
Most brokers now use the fractional pips, 5 Decimal Place Quotes so as to offer forex 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 Market
- EURUSD - 2.0 Pips Spread
- USDJPY - 2.0 Pips Spread
- GBPUSD - 3.2 Pips Spread
- USDCHF - 3.2 Pips Spread
Bid/Ask Price
Bid is the price at which you sell
Ask is the price at which you buy
If the bid ask quote for EURUSD is 1.29140/1.29170
Bid/ask= 1.29140/1.29170
Therefore:
Bid Price =1.29140
Ask Price =1.29170
Example of Bid Ask on MetaTrader 4 - Bid Ask Price MT4 Example
Bid Ask Prices of Various Forex Currencies on MetaTrader 4 - Bid Ask Price Explained
Forex Mini Lots and Micro Lots - Mini Lot vs Micro Lot
As a note, there is also the fraction of 1 Standard Lot, these fractions of the standard lots are provided by brokers so as to make Forex more affordable to traders with minimum capital required to trade micro lots being as little as $5 dollars.
The Fraction of a Standard forex lot is 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 forex micro lots were introduced to make the forex market more accessible to the retail investors and retail traders as well as attract more and more retail traders and retail investors. Maybe this is why Forex has become very popular, even with as little as $100 dollars a beginner can enter this online forex market & start trading FX online.
