Part IV. Spread, Lots, Leverage/margin and profit/loss – joining all...

Forex termnologies - Forex School

Commander in Pips:
 We have discussed many important things, such as Bid/Ask Spread, Leverage, margin, Base and Quote currencies, pips, pip value, profit, loss, etc. So, I think you need to reinforce this knowledge – these items will be crucial for further moving through our FX School.

Pipruit: Well, Commander that was very interesting to solve different tasks previously, so I’m ready.​

Spread, Lots, Leverage/margin and profit/loss - Forex School
BASE AND QUOTE CURRENCIES

Commander in Pips: Ok, tell me what you know about Base currency.

Pipruit: Base currency is a first placed currency in any pair and it stands before slash “/”. For example, NZD/JPY – NZD is a Base currency. Also it shows what currency will be traded, if I intend to make the trade. Specifically the fact that NZD stands at first place (before “/”) tells that I will Buy or Sell particularly NZD.​

Commander in Pips: That’s right, and what does Quote currency tell us?

Pipruit: Let’s assume that we are talking about the same NZD/JPY pair and we’ve said that first placed currency shows what particular currency I will trade. That’s true. The Quote currency, in turn, stands at second place, i.e. after slash “/” and tells us for what currency I will Buy or Sell in exchange for NZD. In our case this is JPY. In other words, Base currency takes function of some kind of product and Quote currency - of money to exchange for that product. When you buying some goods in store (Base currency), you should to pay for it (Quote currency.) If you would like to sell some Item on EBAY (Base currency), you will get cash for your items (Quote currency).​

Commander in Pips: Very well. But you missed some important qualities of Quote currency…

Pipruit: Oh, yes, Quote currency determines the results of the trade. It means that whatever profit or loss you get, it will be shown in terms of quote currency (although it will be automatically converted by the Broker into the currency that your trading account has been initially set up to use). For instance, if we will get profit from a rise of the NZD/JPY rate from 63.00 to 64.00 – this profit will be in terms of JPY and for 100 000 units of Base currency it will be 1000 Yen.​

LOT TYPES

Commander in Pips: Excellent! And what does “Lot size” mean? What kinds of Lot types are you familiar with?

Pipruit: Lot size shows how much Base currency will be traded in terms of units. First, we should look at the base currency of any pair; let’s suppose that this is EUR/USD. Then we should take a look at Lot size. If Lot, for example, equals 100 000, then it means that we will trade 100 000 EUR for USD whatever amount of USD needed will be.​

Commander in Pips: And what amount of USD will that be?

Pipruit: This, in turn, depends on the exchange rate. Say, EUR/USD=1.32 shows, how many units of Quote currency I will have to pay or get for one unit of base currency, depending on direction of trade. In this case for each EUR I will pay or get 1.32 USD. Returning to our associating of Base currency with Item and Quote currency with money – how much should I pay in USD for every 1 EUR I buy, or how much I will get in USD for every 1 EUR that I sell.​

Commander in Pips: That’s right – the rate shows the price of Base currency in terms of Quote currency. So, what types of lots are commonly used on the forex market?

Pipruit: Ok – 

1. Standard lot = 100 000 units of Base currency;

2. Mini Lot = 0.1 of Standard Lot = 10 000 units of Base currency;

3. Micro Lot = 0.01 of Standard Lot = 1000 units of Base currency;

4. Other lower Lots, sometimes it calls as “Nano Lots” = 0.001 of Standard lot = 100 units of base currency;

5. Free lot size – some brokers allow to choose any lot size by the client at wish.​

Commander in Pips: Good, I see you’ve done well, with this material.

BID/ASK SPREAD AGAIN

Commander in Pips: Now, what does Bid/Ask spread mean and how you understand it?

Pipruit: Very often, but not always, there are no other commissions and fees except Bid/Ask spread. So, this is a part of my transaction costs. Different pairs could have wider or tighter spreads, depending on liquidity and trading volume. Major pairs have the smallest spread; exotic pairs usually have much wider spread.

The major point here is that Bid/Ask spread belongs to broker and is provided by broker and we should treat it as quotes at which broker (but not you!) wants to Buy (Bid price) and Sell (Ask or Offer price). For us in turn, it means that we can Sell at the Bid price (because broker wish to Buy not higher than at Bid price) and we can Buy at the Ask price (because broker wishes to Sell not lower than at Ask price).​

TASK #1

Commander in Pips: Assume that your trading account is in USD. You intend to Buy USD/JPY in the amount of 1 standard lot. Currently you see these numbers on the broker’s quote board: USD/JPY 82.52/82.54.

After some time, you see that you have some profit on your position and decide to close this trade. In this moment the rate has changed and you see such numbers: USD/JPY 83.38/83.40

Calculate result from this trade, taking into account a Bid/Ask spread.


Pipruit: 

1. In first part of trade we intend to Buy 100 000 USD for JPY. As we’ve talked we have to buy at Ask price, that stands second (after slash “/”) – 82.54.

2. To close the trade we have to make reverse transaction, i.e. Sell USD/JPY. We have to do it at Bid price that stands first (before slash “/”) – 83.38.

3. So, result in pips will be: 83.38-82.54 = 0.84 pips.

4. Now, we have to convert it in our deposit currency, that is also Base currency, applying the formula that we’ve discussed previously:

pip/exchange rate=0.84/83.38 = 0.0101

5. All that we left to do is to multiply profit in pips of Base currency for lot size = 0.0101*100 000 = $1010. Nice profit, by the way. ​

MARGIN AND LEVERAGE

Commander in Pips: You’re absolutely right. Very nice, that you’ve taken care with this question. Now, let shift to Leverage/Margin question. Tell me, how you understand such terms as Margin and Leverage?

Pipruit: Well, maybe I’m not quite correct in my understanding, but due to your examples and explanation, I have a notion about Leverage as some kind of temporary Loan from a broker. And the terms of this “Loan” equals the time, while I hold my opened position. The value of the loan equals the value of all opened positions excluding the initial margin requirement.

Margin, in turn, looks like some kind of precautionary balance or security deposit, that makes broker feel himself calm, comfortable and not worried about returning of whole “Loan” by me. Because, if something turns wrong, his software will be able to close my positions before the moment when my trading loss exceeds the initial margin.​

Commander in Pips: That’s a very thorough reply.

Additional thoughts about leverage and margin:

- Each broker requires an initial minimum amount of money for start trading. It is called “initial deposit”, “account margin”, “trading deposit” or something like that. The value of this start-up sum of money could be different and depends on your Broker and trading conditions. But once this amount has been transferred on you trading account – you can start trading.

- Your initial deposit could be greater than the minimum requirement from the Broker. Say, a broker demands $1000 as initial margin for a trade and you have $3000 in your trading account. That’s fine. Broker will lock just $1000 and allows you to borrow according to leverage ratio. $2000 will be free and could be used to open additional positions. When you close the trade, your broker will unlock your $1000, then add profit or subtract the loss from your trading account balance.

- ! You should clearly determine all details of margin calculation and mandatory position closing procedure with the Broker before opening an account or placing a trade!

TASK #2

Assume that your broker provides 100:1 Leverage and you intend to open 1 standard lot in EUR/USD at 1.32, two standard lots in USD/CHF at 1.08 and one standard lot in NZD/JPY at 63.00. How much money should you have in your trading account to be able to open all these positions?


Pipruit: Hm, I see one problem with this task. More properly, a couple of problems…​

Commander in Pips: And what are they?

Pipruit: First, I need to know in what currency I should make my initial margin deposit with. Second, I need to know cross rates of my positions to this currency, otherwise I could not estimate the initial margin requirements with just single currency.​

Commander in Pips: You’re right, Son. You are becoming a real professional before my eyes. Ok, say, you have to make that initial deposit in USD. The USD/JPY rate is 82.50

Pipruit: Ok, let’s see then. The first step is to calculate the value of all positions in their quote currencies:

1. EUR/USD 1 lot at 1.32: 100 000*1.32 = 132 000 USD;

2. USD/CHF 2 lots at 1.08: 200 000*1.08 = 216 000 CHF;

3. NZD/JPY 1 lot at 63.00: 100 000*63.00 = 6 300 000 JPY.

On the second step we should convert all these sums in USD:

1. 132 000 USD demands no conversion;

2. 216 000 CHF at 1.08 rate equals 216000/1.08 = 200 000 USD;

3. 6 300 000 JPY at USD/JPY=82.50 equals 6 300 000/82.50 = 76 363 USD.

So, totally we have position of 132 000 + 200 000 + 76 363 = 408 363 USD.

Well and know is quite simple – the leverage is 100:1, then, we would need –

408 363USD/100 = 4083.63 USD.

Commander in Pips: Well done, son. But you made one operation that was absolutely unnecessary...

Pipruit: I know, Sir. I forgot that the number of lots shows the quantity of units of Base currency. So, as my deposit’s currency coincides with base currency there is no need for conversion operations as with USD/CHF pair. My deposit in USD and the Base currency in USD/CHF also is USD, so I just have to take number of lots of this pair. That’s all.​

Commander in Pips: Yes, but this is insignificant mistake. I might say that this is not really a mistake at all, just an unnecessary extra step operation. But overall, your calculation is correct.

ADDITIONAL TALK ABOUT MARGIN

Pipruit: Let me ask just one question Sir. And what will happen, if the floating loss on my open position will become greater than the margin?​

Commander in Pips: This is a very important question, Son. Let’s take previous example. As you’ve calculated, we need at least 4083.63$ as initial margin just to open positions. This sum will be locked as soon as we open these positions.

Now, take carefully follow my thoughts:

1. If we will transfer as a margin precisely 4083.63$ then our position will be automatically closed if market will move against us by even 1 pip. Because in this case our deposit will become insufficient - less than required minimum margin, estimated by the Broker. So, if your deposit only equals the minimum margin that demanded by the broker, then you can’t hold your positions open if the market moves even 1 pip against you. Here is the major formula for calculation:

Maximum Floating Loss = Trading account balance – demanded Margin

What does it mean? Let’s assume that initially you’ve transferred on your trading account $5000 (i.e. your initial trading account balance) and demanded margin by Broker, according to our estimation in previous task – 4083.63. It means that the maximum floating loss, that you can hold prior the mandatory close your positions by the Broker equals:

5000-4083.63 = $916.37.

Pipruit: Ok, I understand that. But what is a floating profit or loss?​

Commander in Pips: Well, all positions that you’ve opened and not close yet are marked – to – market in real time. Broker software automatically recalculates after every quote change current profit or loss on your open trades. Because this profit or loss changes with each quote changing, i.e. price changing, it is called “Float”. Quotes are floating in time, so, the result of open trades follows them.

Pipruit: And if my loss will become greater, Broker will close all open positions or just some of them? Because if Broker will close some of them, the margin will be partially unlocked and other positions could be financed with it?​

Commander in Pips: You’re right. For example, if your loss in our example will exceed 916.37$, then Broker could close, for example, just EUR/USD position. Since it demands 1320$ of margin – it will be unlocked and added to your account assets. But what position will be closed and the procedure of mandatory closing of positions is determined by the Broker. Some will close all positions, some will close some positions in a specific order. Some will start closing positions before your available balance reaches zero. So, you have to find out it with scrutiny and all nuances before start trading!

Pipruit: And what is a trading account balance? Does it always equal to initial transfer?​

Commander in Pips: Of course not. It changes as the result of your trades. If you make some profit your balance increases with it amount, if you take losses – the balance decreases. For example, your initial deposit transfer was $5000, then you make 1 trade with profit, say $786 and 2 trades with loss, say $120 in each trade. So, your trading balance will be 5000 + 786 – 120 – 120 = $5546.

Pipruit: Thanks, Commander. I think that everything becomes clear now.​

Commander in Pips: Sounds good. Take the last task here then.

ADVANCED TASK #3

Assume that you intend to open a trading account with some broker. You have made your own analysis and come to conclusion that AUD/USD should rise in nearest future, so you intend to open a Long position on AUD/USD. The current rate on AUD/USD = 0.9893/0.9895.

You want to invest in the long term and hold the position for about 3 months. Your broker said that you will have positive swap about $3.2 per day* for each standard lot of AUD/USD, because the interest rate on AUD much greater than on USD.

Also you can’t exclude the possibility of some retracement on the market to the downside (i.e. against your position) but you are not sure that it definitely will take place. But you believe that it will not be greater than 160 pips against you.

The broker is ready to provide you with 100:1 leverage. The question is:

How many lots of AUD/USD can you open if you want to invest $10 000 as your initial trading deposit?

*For simplicity we assume that you get swap for all 3 months in the beginning of the trade. But in general swap accumulates on daily basis, so you can’t count on future swap to help you against today’s price moving against you.

Pipruit:
 Cool! A very practical task! Let’s see…Wow, I think we will need some equation, although it will be simple. In fact, we should calculate all parts in terms of standard lots.

1. Let’s point the number of standard lots that we need to calculate as “X”.

2. Then, the Broker’s demanded margin in terms of lots will be: (100 000*X*0.9895)/100 or 989.50*X. 0.9895 is an Ask Quote that we should use, because we intend to Buy. Also we have to use quote in margin calculation, because our trading account currency coincides with Quote currency and not with Base currency;

3. Now let’s estimate the sum of swap – it will be $3.2/day per standard lot and I will hold position for 90 days (i.e. 3 months). Then the total swap sum will be: 3.2*90*X.

4. The possible drawdown of my position due to retracement against me will be 160 pips: X*100 000*0.0001*160 = 1600*X

5. Finally, we can create an equation:

Swap value (because it positive) + initial deposit = Margin requirements + possible negative drawdown
3.2*90*X+ 10 000 = 989.50*X+1600*X
2589.50*X – 3.2*90*X = 10 000
2589.50*X-288*X = 10 000
2301.5*X=10 000
X = 4.34


If we can’t open fractional number of lots, so we can open just 4 lots. 
If we can, then we may open 4 standard lots + 3 mini lots+4 micro lots.​

Commander in Pips: Let’s see:

1. Demanded margin will be: 4.34*100 000*0.9895/100 = - $4294.40

2. Possible negative drawdown: 4.34*100 000*160*0.0001 = - $6944

3. Initial deposit transfer: +$10 000

4. Positive swap for 3 months: 3.2*90*4.34 = +$1249.92

5. Balance: -4294.43-6944+10 000+1249.92 = +$11.49 (due to rounding)

Excellent work, Son. 10 000$ indeed will be just enough to make this trade with 4.34 lots.

Comments

mrVynes
7 years ago,
Registered user
Helo,

In Task #2, we calculated the exact amount($4083.63) needed for the 3 trades. Then you explained that it won't do as a margin because the positions will be closed as soon as the market moves 1 pip against us, but a little further down you call this the "demanded margin by Broker". How can this be? Would it be allowed to place those 3 trades (or the one placed last of the 3) if it leaves nothing as margin? Isn't there a specific amount needed as margin (on top of the $4083.63) that will be locked for duration of the trade?

Please excuse my confusion I realise I might be missing some fundamental thing here...

Thanks
Sive Morten
7 years ago,
Registered user
> Helo,

In Task #2, we calculated the exact amount($4083.63) needed for the 3 trades. Then you explained that it won't do as a margin because the positions will be closed as soon as the market moves 1 ..

Hi mrVynes,
4083.63 is a margin itself. This is precise the sum that broker demands to allow you open all this three positions.
Still, here we discuss only major calcuation without margin separation on initial and maintainance. They should be slightly different. We will return to discussion of margin as it should be in later chapters. This chapter is dedicated to bit different topic - how to calculate minimum margin. Here we assume that this margin is initial one and broker lets to open position with it.
mrVynes
7 years ago,
Registered user
> Hi mrVynes,
4083.63 is a margin itself. This is precise the sum that broker demands to allow you open all this three positions.
Still, here we discuss only major calcuation without margin separation..

Understood, thank you.
Marky$
6 years ago,
Registered user
Hi Commander in Pips,

The Military School is the best material explaining FX market I've ever read. I've read a few textbooks before.
The content and form are written according to KISfSP rule (Keep It Simple for Stupid Pipruits):)
It's really big deal and I appreciate it a lot.
Although, I'm a little bit confused with Task #1, point 3. There is equation: 83.38-82.54=0.84 pips.
In previous chapters you said that 1 pip is the smallest unit of currencies ratio change and for JPY it's 0.01 change of ratio = 1pip.
Shouldn't there be 84 pips or just 0.84 (without unit, for further calculation)?

Once more big thanks for MS.
Sive Morten
6 years ago,
Registered user
> Hi Commander in Pips,

The Military School is the best material explaining FX market I've ever read. I've read a few textbooks before.
The content and form are written according to KISfSP rule (Keep I..

Hi Marky,
sure, you're right. Thanks, we'll fix it. In fact, word "pips" is needless here.
serega123ok
5 years ago,
Registered user
I am confused about to what currency ralates lot size, to quote or base.

And there i take definition from glossary in yellow field and i see contradiction.
Help me better understand it, please.
Rens
4 years ago,
Registered user
> I am confused about to what currency ralates lot size, to quote or base.

Hi Serega123ok,

Although I'm new here, I think I can explain which one is correct. Sharp notice btw.

Feel free to correct me if I'm wrong, but I think my explanation is the right one.

A lot is based on [U]base currency. A lot could be thought of as 100,000 of a "product" you want to sell/buy. Because as explained in the course, we should see base currency as the "product" that is traded and the quote currency is the "money" we buy/sell the product with/for. As in normal life we indicate the amount of "products" we want to sell/buy and that is priced at XXX amount of money.
For example: We normally don't go in a store buying beer, laying X amount of money on the counter and ask how many cans of beer is this. It's the other way around. We take X amount of cans of beer and that will result in X amount of money we have to pay. Or in selling prespective, the storeclerk sells X amount of cans of beer for X amount of money.
So the amount with which we indicate a forex trade (lot, mini lot, micro lot etc.) is based on the base currency, as in normal life we base trades on amount of product bought/sold, then we get the "price" it's worth.
I hope my explanation and example are clear.
Rens
4 years ago,
Registered user
Sufficient margins

Hi Sive and others,

One thing isn't clear to me when trading with leverage. Let's take a simple example for the sake of understanding.

Let's say I buy a mini lot USD/CHF (1.00/1.50) at 100 x leverage.

My initial deposit (margin) should be $10,000:100=$100

Now let´s say the market moves 1.5 pip (1 pip base currency) against us. That's x10,000 pips for the total amount we're trading with ($10,000), so 10,000 pips. Which is 0.0001x10,000=$1.0000 (1% of our initial margin)


I've simplified the example of Task #2, but kept the x100 leverage. In this task it was said that with just the initial margin invested, you couln't withstand the market moving against you with 1 pip.

As I've just calculated the market moving against you with 1 pip costs you just 1% of your initial margin (your collateral). So concluding from this, shouldn't the market be able to move 100 pips, before burning through your initial margin? Ok, fair enough... Our broker keeps, let's say a 10% margin for closure, but then still the market may move 90 pips against us.

Could someone please explain this to me?


Thanks so much in advance!
Hamza Samiullah
2 years ago,
Registered user
Nice work.. excellent..
willie123
2 years ago,
Registered user
Pips and Equity Uncle Will

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