Leverage, Gearing and Lots. How to Make Money Trading Curencies Online.
One of the first things you´ll notice when you head to an online forex broker, is that most of them bang on about their gearing or leverage. This is an important concept to understand, as gearing allows you to execute forex trades for larger amounts than you would expect. It allows traders to punch above their weight in the forex markets, and is particularly useful for retail investors and online forex traders.
But first of all, let´s talk about Lots- which is a measure of the amount of currency that is being traded. You will hear the term “lots” being banded about quite a bit.
Historically, forex was traded in specific amounts called lots. The standard lot size is 100,000 units. You can also trade mini lots (10,000 units), micro lots (1000), and nano lots (100 units).
- Standard 100,000
- Mini 10,000
- Micro 1,000
- Nano 100
Currency prices are measured in pips, which is the smallest increment of the currency. Because the actual movements in pips in normal day to day trading is relatively small (even tiny some would say), you need to trade big volumes of a currency in order to make a decent profit or loss.
Let’s assume we will be using a 100,000 unit (standard) lot size. We will now recalculate some examples to see how it affects the pip value.
Let´s say you were interested in trading USDCAD which was at 1.0205. Each pip is worth 0.001/1.0205 $0.0009799118 or 0.098 cents per pip.
Not very much, is it? But then if you trade a lot of 100,000 each pip movement is worth much more.
Most retail investors don´t have $100,000 lying around waiting to be invested in the currency markets (some do!). This is where leverage or gearing comes in.
Your broker will make the trade of $100,000, as long as you secure the position with $1000- this is called a 100 gearing, as your funds are $1000, but you are taking out positions 100x the value of that. Your broker knows that the currency is not going to go down to zero, so he can manage the risk his end. And he attracts more customers as they can take positions in the market that are potentiall going to make them a good return, rather than making fractions of pennies.
Brokers will generally require a deposit, known as “account margin” or “initial margin.” Once you have money in your account, will then be able to trade.
If the gearing is 100:1 and you want to open a position worth $100 grand, and you have $3,000 in your account, your broker will ear mark $1,000 as security, or “margin,” and lend you the rest. Any losses or gains will be taken away or added to the balance in your account.
Remember, your broker will make money on the spread (the difference between buy and sell price) which will eat into your profit on a successful trade or increase your loss on an unsuccessful one. And they may also charge a commision.
Leverage is a very powerful tool, but just remember that is accentuates profits AND losses. Think of it as riding a bike in high gear. A small movement of the pedals results in a big movement in the wheel. Don´t gear too high, or you will get wiped out when the market swings (unless you have the budget to cover it and markets are noisy and spiky remember.
What is Leverage? Watch The Video Below.