Basic Notions
of Trading

Knowing the
Forex market

What is a PIP?

The PIP is the smallest variation that exists in the price of a currency pair.

If the EUR/USD moves from 1.2250 to 1.2251, that change to the fourth decimal place equals one PIP. The PIP is a fundamental instrument to calculate the gains or losses in your operations.

Something important that you should take into account, most pairs are quoted to four decimal places, such as the EUR/USD, with an exchange rate of 1.2041. In some trading platforms the quotes are presented in up to 5 decimal places but make no mistake, the PIP is the variation in the fourth decimal place.

The exception to this rule, for pairs associated with Japanese Yen, the PIP is represented by the variation in the second decimal. For example USD/JPY at an exchange rate of 108.42. As in the previous case, all platforms add an additional decimal but even so, the PIP is a variation in the second decimal in the pairs associated with the Japanese Yen.

How to calculate the value of the PIP?

Now let’s look at some examples of how to calculate the value of the PIP in the currency pairs in which the dollar is traded first (that is, as the base currency).

USD/JPY

Exchange rate: 119.80

PIP: 0.01

PIP value = PIP / ExRate
0.01/119.80 = 0.0000834 dollars

USD/CHF

Exchange rate: 1.5250

PIP: 0.0001

PIP value = PIP / ExRate
0.0001/1.5250 = 0.0000655 dollars

USD/CAD

Exchange Rate: 1.4890

PIP: 0.0001

PIP value = PIP / ExRate

0.0001/1.4890 = 0.00006715 dollars

Now we will see some examples of how to calculate the value of the PIP when the US dollar is not the base currency but the cross-currency.

EUR/USD

Exchange Rate: 1.2200

PIP: 0.0001

PIP value = PIP / ExRate

0.0001 / 1.2200 = 0.00008196 Euros

To convert the value of the PIP to US dollars:

Euros x ExRate = 0.00008196 x 1.2200 = 0.00009999 dollars

When rounded it would be 0.0001

GBP/USD

Exchange Rate: 1.7975

PIP: 0.0001

PIP value = PIP / ExRate

0.0001 / 1.7975 = 0.0000556 British pounds

To convert the value of the PIP to US dollars:

0.0000556 pounds x ExRate = 0.0000556 x 1.7975 = 0.0000998 dollars

When rounded it would be 0.0001

It is important that you know that you will not have to perform these calculations manually every time you make a trade since trading platforms do this automatically, however, it is important that you know how these operations are formulated.

What is a Lot?

In the foreign exchange market, pairs are traded in lots. There are different sizes of lots, the most used are:

If you want to understand it differently, the lots represent the volume of the transactions you carry out, so the greater the number of lots per trade, the greater the profit or loss generated by an operation.

Now we are going to see an important part within the lots, their participation in the calculation of the profits or losses of your trades.

We will first look at some examples where the dollar is the base currency. We are going to work with a standard lot, that is, 100,000 units of currency.

How to calculate the profits or losses of your operations?

USD/JPY

Exchange rate: 119.80
PIP: 0.01
Lot: Standard Lot of 100,000

PIP value in dollars = (0.01 / 119.80) x 100,000 dollars = US$8.34 per PIP

USD/CHF

Exchange rate: 1.4555
PIP: 0.0001
Lot: Standard Lot of 100,000

PIP value in dollars PIP = (0.0001 / 1.4555) x 100,000 dollars = US$6.87 per PIP

Now we will look at some examples where the dollar is the crossover currency. We are going to work with a standard lot, that is, 100,000 units of currency.

EUR/USD

Exchange rate: 1.1930

PIP: 0.0001

Lot: Standard Lot of 100,000

PIP value in dollars = (0.0001 / 1.1930) x 100,000 euros = 8.38 euros per PIP x 1.1930 = US$9.99734 dollars per PIP

Rounding out would be US$10 per PIP.

GBP/USD

Exchange rate: 1.8040

PIP: 0.0001

Lot: Standard Lot of 100,000

PIP value in dollars = (0.0001 / 1.8040) x 100,000 pounds = 5.54 pounds per PIP x 1.8040 = US$9.99416 dollars per PIP

Rounding out would be US$10 per PIP.

Remember that the value of the PIP will not always be the same for all currency pairs.

Profit and Loss
Calculation

Once you are able to calculate the value of the PIP, calculating profits and losses becomes much easier. Let’s see how it’s done here:

USD/CHF

We are going to buy US dollars and we are going to sell Swiss francs, in other words, we are going to buy the USD/CHF currency pair.

The exchange rate is 1.4525/1.4530 (you already know that it is the bid/ask, that is, sell price/buy price).

As we are going to buy US dollars, the exchange rate that we will use is the ASK, that is, 1.4530 since the exchange rate 1.4525 is for sale.

We buy 1 standard lot, that is, 100,000 units of currency (dollars in this case) at 1.4530.

After a couple of hours, the price reaches 1.4550 so we decided to close the deal.

The USD/CHF is now 1.4550/1.4555. As we are closing the deal, it means that we are selling what we had previously bought. As we are selling, we will work with the BID exchange rate, that is, 1.4550.

The difference between the initial purchase exchange rate and the sale exchange rate at which we have closed the order is as follows:

1.4530 and 1.4550 which in PIPs would be 20 PIPs or 0.0020.

Using the formula that we have already seen, we will calculate the value of the PIP in dollars.

(0.0001 / 1.4550) x 100,000 dollars = US $ 6.87 for each PIP x 20 PIPs = US$ 137.40

Remember that when you buy a currency pair, you use the ASK price and when you sell you use the BID.

What is Leverage?

Leverage is an element that allows you to carry out operations for amounts greater than what you have as initial capital in your account. Putting it very simply, leverage is a multiplier.

You’ve probably heard that leverage is a double-edged sword, what this means is that while leverage allows you to trade larger volumes than you could actually access with your capital, it also involves risk.

What risks? The leverage you choose will also have an impact on the profits or losses you generate, the higher the leverage, the higher the profits may be, but also the losses.

When opening your trading account, you have the option to choose the leverage that you will use, it exists from 1:1 leverage to 1:1000 leverage (the available leverage also depends on the broker you are working with).

Let’s imagine that you decide to open a US$ 1,000 account with a leverage of 1:100, this means that you will be able to carry out operations of up to US$ 100,000 even though your initial capital is only US$ 1,000.

What is the Margin?

The margin is a percentage of your capital that the broker requires you to keep in your account at the time of carrying out your operations. When the capital of your account (that is, the money you invested) falls below what is known as margin required, your broker will start closing some or all of your open positions. Why this happens? To limit your losses and prevent your balance from turning negative.

There are 4 important concepts related to margin that every Trader should know:

Required Margin

The required margin is the capital needed to keep a trade open.

Free Margin

It is the amount of available capital that the account has to open new operations.

Margin Level

It refers to the percentage level of margin in which your account is.

You can calculate your margin level as a percentage as follows:

Margin Level = (Capital / Required Margin) x 100

Margin Call

It is when the capital of the account has reached a certain level of margin (which in some brokers it can be 50% and in others 100%). 

When that level is reached, there is no longer enough capital in the account to open new operations and some may even begin to close.

Example

Imagine that you open a real account with US $ 10,000 and decide to open a 1 lot trade on EUR/USD with a required margin of US$ 1,000.

At the beginning you had a free margin of US$ 10,000, however, when you open 1 lot with a required margin of US$ 1,000 your free margin will be reduced to US$ 9,000.

Let’s also imagine that your broker has set a Margin Call level of 100%, that is, when the margin of your account reaches this level you will not be able to open new operations and if the margin falls below this level, it is possible that they will begin to close some operations.

Now imagine that your trade in the EUR/USD goes against you and the trade is generating you a loss of US$ 9,000. That means your available capital is now only US$ 1,000.

Your Margin Level = Capital (US$ 1,000) / Required Margin (US$ 1,000 of your EURUSD trade) x 100 = 100%

You have reached Margin Call, that means that you cannot open new trades until you close your trade in the EURUSD (which is making you lose US$ 9,000) or the market recovers and goes in your favor. If the trade continues to go against you, it is possible that the broker decides to close it totally or partially to keep your margin level above 100%.