As with other financial markets, Forex has a set of terms and concepts all its own. Some are simple, while others are complex. Beginning investors should gain an understanding of each one if they want to be successful in this market. Having a good knowledge base and making wise decisions increase the chances for profit. Rather than jumping into Forex with both feet, take some time to familiarize yourself with these terms.
A pip, also referred to as a point, is the smallest price increment that can be made by a currency. For example, one pip equals 0.0001 for a euro/dollar currency pair and 0.01 for a dollar/yen currency pair. A lot is the standard unit size used in a transaction. In general, a standard lot equals 100,000 units of a base currency or 10,000 units in the case of a mini-lot and 1,000 units for micro lots. Some dealers allow investors to trade in any size, down to one unit.
A pip value is simply the value of a pip and this can be either variable or fixed depending on the currency pair. For the euro/dollar pair, the pip value for standard lots is always ten dollars, one dollar for mini-lots, and the pip value for micro lots is ten cents. Investors should learn how to calculate pip values. This requires understanding the quoting conventions for each currency and the difference between the base and terms currency, the first and second currency in the pair, respectively.
Leverage is something that makes Forex markets very attractive to investors. This is the ability to place the account into a position that is greater than the total account margin. For example, traders with $1,000 margin in their accounts leverage their accounts 100 times, 100:1, when they open a $100,000 position. To calculate the amount of leverage used, simply divide the total value of the open positions by the total margin balance in the account.
Leverage is a much-misunderstood concept and investor misunderstandings often result in losses when doing Forex trading. The concept can work either for or against an investor, making it a double-edged sword. Brokers lead traders to believe that leverage is about the maximum that can be achieved. The truth is, the key factor is how much leverage is used. Traders should not confuse a broker stating how much they are allowed to leverage with how much they should leverage.
It is important to understand that leverage is the degree to which the investor is using borrowed money. The individual is using this money to approve his or her speculation capacity, increasing an investment’s rate of return. A related term is margin, which is the amount of collateral an investor deposits with the broker in order to borrow currencies.
Some marketing gurus use the terms margin and leverage interchangeably, confusing investors. Therefore, it is important that individuals understand these and other key terms relevant to the Forex market prior to doing any Forex trading. Understanding the basics will allow traders to maximize their returns and enjoy a long career of Forex trading.