Lots, lot size, and leverage are concepts used in forex trading that can be difficult to grasp for those who are just starting to trade.
A lot in forex trading represents how much of a currency you are trading and it represents the size of the trade (position) being opened. In the stock market, a trader will buy a specific number of shares as this represents the volume of the trade. In the options market, contracts are purchased.
Lot Size Classification
Whenever you place a trade, you have the option of choosing the lot size. The size of your trading account and the amount of leverage you have at your disposal determine the maximum lot size you can use. Lot sizes are divided into three main categories:
A micro lot is 1,000 units of the base currency and is usually the smallest position size you can trade with. If you trade one micro lot of the EUR/USD, the pip value is always $0.10.
A mini lot is 10,000 units of the base currency. If you trade one mini lot of the EUR/USD, the pip value is always $1.
A standard lot is 100,000 units of the base currency. If you trade one standard lot of the EUR/USD, the pip value is always $10.
How to Calculate the correct Lot size?
Suppose you want to enter a trade on the EUR/USD with a stop loss of 100 pips. And let’s say you can afford to risk $20 on this trade. How would you calculate the correct lot size to achieve this? Here are the steps:
- Divide the amount you want to risk by the number of pips you’re setting your stop loss at: $20/100 pips = $0.20 per pip.
- Divide this value per pip ($0.20) by the pip value of a micro lot on the EUR/USD ($0.10):
$0.20/$0.10 = 2. This is the number of micro lots you need trade. 2 micro lots can also be written as 0.02 lots.
To perform this second and final step, it is important to know how to calculate the micro lot pip value of the specific currency pair you’re trading because the pip values of different currency pairs can differ. To find out exactly how to calculate pip values, please take a look at ‘What is a Pip?’.
Let’s test our calculation:
The pip value of 0.02 lots is $0.20 per pip. The number of pips at risk is 100. Multiply the number of pips (100) by the pip value ($0.20) and you get $20, which is the correct amount you want to risk.
What is Leverage?
Using leverage means that you borrow capital from your forex broker or a connected third party, with which you can open much larger trades than which you would have been able to open without access to any leverage. The forex market is generally much less volatile than, for example, stock markets. Currency pairs can take days and even weeks to move just a couple of percent. This means that without using leverage, it is unlikely that you will make a good return on your investment in a relatively short period of time. First of all, a large part, or all of your capital will be tied up in a position (or positions) that will probably not move fast enough to satisfy your expectations of a good return. And, of course, there is a chance that the market will not move in the direction you anticipated.
As a simple example, if you have access to a $300 trading account with 1:500 leverage, you can easily open 5 trades on the USD/CAD of 1 micro lot each. Without any leverage, these trades would require capital of $5,000 because that is their combined notional value. However, with 1:500 leverage, only $10 of your $300 account would be reserved as a type of deposit to open these 5 trades and keep them open. Of course, there is usually at least a small floating loss during the lifetime of any trade. A floating loss will occupy additional capital in your trading account (besides the $10 used for the initial opening of the trades).
Leverage increases both profit potential and risk considerably. To learn more about leverage and how a margin forex trading account works, please read ‘What is Equity and Margin?’