Today we are going to talk about one of the most important topics in the trading world and that is “what is lot size and how to calculate lot size accurately”. In order to understand this topic; we must set base first and need to understand the following topics.
- What is a Pip in Forex?
- What type of Forex Trading Account You Have and its currency denomination?
- How to calculate pip value in Forex?
- What is Risk Management in Forex and how to calculate Risk and Reward in trading?
- What is Stop Loss in Forex?
- how to calculate Forex lot size?
What is pip in Forex
The easy answer is a pip in Forex markets is a fractional change or movement of currency pair from 1 point to another. This is also called a fractional change in price after a decimal point. If you are still confused! Don’t worry; let me break this down for you.
Let’s take an example of USDJPY currency pair.
Currently this pair is trading at 109.354. If this price moves one point up or down, the difference will be called one pip move. If the price moved from 109.354 to 109.355, this means the pair is moved 1 pip.
109.355 – 109.354 = 0.001 = 1 pip
109.359 – 109.354 = 0.005 = 5 pips
Here is another visual example to establish more understanding about pip value.
As can you see in above picture, the USDJPY pair value is increased from 104.083 to 104.084. This means the pair is moved 1 pip up. In more financial terms, the USD (Dollar) is appreciated against Yen or the Dollar is become stronger against Yen currency. If you didn’t understand the last statement then don’t worry! we will have plenty of opportunity to learn more financial jargon.
Now can you guess “how many pips USDJPY moved in second example?” yes correct, it’s 5 pips. Because the difference between 104.088 – 104.083 = 0.005 = 5 pips
The important thing we need to remember that the pip in forex changes between brokers to brokers. Sometimes the broker quotes 3 decimals point after digit and sometimes 4. Let’s understand this with FXCM Broker example.
FXCM Forex Broker
let’s take a look at how FXCM pip value is quoted in the trading station. FXCM quotes 2 digits after decimal for all JPY currency pairs. For example USDJPY, GBPJPY, CADJPY, NAZDJPY, AUDJPY, CHfJPY,EURJPY.
As highlighted in red rectangle, the pair USDJPY value is provided in 2 digits after a decimal.
For Non-JPY pairs, FXCM quotes 4 digits after the decimal point (i.e. 0.0001). these pairs are EURUSD, GBPUSD, CADJPY, EURGBP, AUDCAD etc
The above picture provides the EURUSD pair example and the pips are quoted in 4 digits, after the decimal point.
As I explained above, these pip values changes from broker to broker but the principle is the same.
So far so good! Now let’s move on to the next topic and understand the different Forex Trading Accounts and how currency denomination affects the pip value calculation
2. What type of Forex Trading Account You Have and its currency denomination?
Now in order to calculate pip value, we must understand the type of Forex Trading Account we have and the currency denomination of the account. Let me explain this in detail. When we open an account with any Forex Broker, they provide us three options;
- Standard Trading Account
- Mini Trading Account
- Micro Trading Account
And denomination of the account means the currency we used to open the account. Let’s say if I am living in the UK and I want to Trade Forex Currencies, I can open an account in GBP (Great Brish Pound) or sterling and so my Forex Account denomination would be GBP (£). Similarly, if you are living in the USA and want to open a forex trading account, you will use a Dollar (USD $) to open this account. Your currency account denomination would be US dollars.
Standard Trading Account
In Forex Standard Account, when we trade 1 lot, behind the scene, the broker trades 100,000 for us. And pip value for 1 lot would be 10$ in a standard account.
Mini Trading Account
In Forex Mini Trading account, when we trade 1 lot, behind the scene, the broker trades 10,000 for us. In mini account the pip value would be 1$ always.
Micro Trading Account
In Forex Micro trading account, when we trade 1 lot, this means the broker will trade 1,000 for us and the pip value would be 0.10$.
If your account denomination is US Dollar, the above pip values will work like charm! Just to make this concept more interesting, we will consider opening an account in GBP currency and will see how this effects the currency conversion for pip value calculation. Just bear with me and I’ll explain this as we move forward.
Some brokers provide you with the facility to trade on your behalf and that is called managed Account. Usually, the fee to open these sort of accounts are higher and it starts from 25k and above but also you need to consider the percentage/cut the broker will keep from profit. They usually call it to account for operation or service fees.
If you are just starting forex trading, I’ll highly recommend starting with a Demo account and practice, practice and practicing your strategies before jumping into real markets. We will cover the trading strategies and how to trade in other sections.
Now since we have understood the different Forex Account Types and Currency Denomination, let’s move forward to calculate the pip value for GBP Account Denomination.
3. How to calculate pip value in Forex
Now let’s set the stage. To calculate pip value we are setting the following assumptions. Our Forex account type is Micro Account and we have a deposit of £1000 pound. The account is opened with FXCM broker and as we explained above the account type is Micro Account; when we will trade 1 lot, the lot value would be 1,000.
This is simple so far, now let’s take an example of JPY Currency pair USDJPY. As we know now the FXCM platform quote 2 digits after the decimal points so the pip movement would be 0.01. now let’s calculate the pip value:
Pip Value = 0.01 X 1000 / 104.08 (exchange rate of USDJPY)
Pip value = 0.0960 ($)
This is how we calculate the pip value and in above example the value is 0.0960 US Dollar. As mentioned, our account denomination is GBP (Pound), we need to convert this to GBP currency. The pair we will use is GBPUSD for exchange rate conversion. For this currency conversation, please note the GBP is the Base Currency for the GBPUSD pair. If you do not understand the Base Currency or Counter currency then don’t worry, I’ll explain this in more detail later.
so in our case, the pip value in GBP would be £0.06.
I hope the idea of calculating pip value is cleared now. most of the time pip value is already provided by the Broker Trading Platform. In case it is not provided, now you have the ability to calculate this!
Now this calculation will slightly change when GBP is a counter currency in the exchange rate. If you still want to read this topic in more detail, please visit another detailed article calculate pip value in Forex.
since now we understand Pips, Forex lot, and how to calculate pip value, let’s move on to our next topic and that is “Managing Risk and Reward in Forex” with help of pips.
4. What is Forex Risk Management
Forex Risk Management is all about how much risk you are willing to take when you open a trade. Mostly the Risk is identified before the trade is executed. We all know the Forex is a trillion Dollar Market and every day there is approximately 1.4 trillion transactions are executed all over the world.
Therefore it is volatile and brings Risk as well as opportunities. Professional Traders always manage their Risk and open trade with not more than 1-2% of their trading balance. We calculate Risk in terms of the amount we want to invest in and the pip value that will be traded with that amount.
There are different Risk Mitigation strategies which trader can follow to avoid major losses and some of them include, using stop loss, by not trading correlated pairs, Money management, and disciplined trading psychology.
These topics are covered in the Forex Risk Management article in more detail. therefore now it suffices that we understand the Risk and since we know the equity we will invest as per the above example, let’s find the Stop Loss price.
What is Stop Loss and How to Calculate Pips
Stop Loss is a level or price at which we exit from the trade. We determined this level, before executing the trade or entering the market. Sometimes we use Swing Low/High for stop-loss point and sometimes it’s just a previous candle low/high. There is no hard and fast rule but generally, the stop-loss price level is well far away from the market fractal point or resistance. We will discuss trading strategies in a separate article.
Stop Loss example USDJPY currency pair
Now let’s take an example of the USDJPY pair and understand the stop loss level.
Consider the above picture and look into section “A”. The market is moving between 107.030 and 107.174. We establish our understanding that the market will go down once it breaks the previous resistance price of 107.030. Since we are establishing our bias towards the Short/Sell trade, we will place a stop loss on the above level. If we are predicting the market will move low, what if the market can prove us wrong and go in the opposite direction. So to cover that scenario, we choose the previous swing high point and in this example, the price level at swing high is 107.174.
FXCM broker quotes two digits after the decimal point for JPY pairs.
Stop Loss in Pips = 107.174 – 107.030 = 0.14
To calculate stop loss, we will first subtract the low price (107.030) from the higher price (107.174) and this will give us the difference of 0.14 points. So in another word, our pip difference between the entry point and stop loss is 14 pips.
I hope now the stop-loss concept is clear and we now know how to calculate pips but if you want to explore more about stop loss and find out different types of forex orders then check my other articles.
Now let’s explore the final piece of this puzzle and that is how to calculate lot size according to our defined risk money.
How to calculate lot size according to defined Risk amount
To calculate lot size, we need the following information and we have already learned how to calculate these.
- Equity Percentage to Trade ($ Amount)
- Number of stop loss pips
- Pip Value
Calculate Lot Size example with USDJPY
As shown in the above USDJPY Stop loss picture, we calculate the stop loss pips that were 14 pips. We have also learned how to calculate the pip value and for USDJPY the pip value for the mini account was 0.06.
Now combining this information, we are risking 2% of 1000 ( our trading balance) and the risk amount would be £20. Stop Loss Pips we have already extracted and that is 14 pips and the formula would be;
lot size = (2% of 1000 / Stop Loss Pips 14) X pip Value 0.06
lot size = (20 / 14)*0.06 = 0.08 micro lot size
Similarly, if our trading account is micro or standard; we can use respective pip values to calculate lot size. For the micro account, the pip value was £0.6 and for the standard, it will be £6.
I hope you enjoyed this article as much as I did writing it! Don’t forget to check other articles trailing stop loss limit orders and other types of market orders.