Explanation of Spread, Leverage and Lot

Forex traders are also known by the technical term trader. They usually perform foreign exchange trading on 10 to 20 days a month. They trade only when the analytical tools they use show clear market trends.

If the days are uncertain, the traders simply suspend trading. By this suspension, they limit any losses. Forex trading moves on a second-by-second basis in the ten-thousandths of a digit range. The trader keeps a constant eye on the activity on his trading platform in order to react immediately to changing prices.

The technical term “pip” appears primarily in connection with the term “spread”, i.e. the fees incurred during trading. “Pip” refers to the fourth decimal place. Foreign exchange trading is regularly subject to the price fluctuations of the currencies on which it is based. The price fluctuations are relatively small in short-term foreign exchange trading because the traded positions are usually closed out (sold) within a short period of time, within hours. The Bank bears only the risk of the relatively small price fluctuations. Ask and bid prices are continuously quoted on the market, which are only valid for a short period of time and are therefore subject to permanent changes.

What is a spread?

A spread is the term used to describe price changes in foreign exchange trading. These are expressed in the unit pip. The spread can take on different sizes depending on the currency. In general, for currencies with only one digit before the decimal point, for example USD against EUR, the exchange rate changes by a factor of 0.0001 for one pip. For other currencies with two digits in front of the decimal point, one pip would correspond to a change in the exchange rate of 0.01. The number of units bought on the corresponding currency pair is also decisive for how high a pip turns out to be. The more units purchased, the more the exchange rate will change due to the larger proportions. Thus, in the forex business, larger investments are more worthwhile, although acceptable returns can also be achieved with smaller volumes of capital.

In connection with the pips, the so-called tick should be mentioned. This is the smallest possible price change in any currency pair. Here the value of the pips, depending on the amount, is then given in the format 0.1, 0.2 and so on. The information about the ratio of the spread can usually be found on the page of the respective broker.

What is leverage in FX trading?

The so-called leverage actually refers to a leverage effect, which can also be understood in the literal sense. Leverage in Forex trading always refers to the ratio between the actual value of a commodity and the available equity.

To explain this more clearly, an example will be given. The leverage value is expressed in the form of 1:100 or, conversely, 100:1. If now approximately 1 euro is used, but the purchase value of the appropriate foreign exchange is 100 euro, then this leverage ratio means that the broker pre-pays the necessary 99 euro. Thus, it is not necessary to trade with horrendous equity, it is simply borrowed money from the broker or respective credit institution used. The higher the ratio of the leverage is specified, the more shares can be acquired with lower equity.

However, the effect in the market development looks the other way around. With a ratio of 1:100, the corresponding value on the market must lose 100 points before the capital is used up. However, with a leverage of about 1:400, the market only has to lose 25 before the capital is exhausted. Therefore, the greater the leverage, the higher the risk of losing the invested capital. However, with the risk, the possible returns also increase by leaps and bounds.

What does the term lot mean?

A lot is the quantity of purchased units of a particular derivative on the foreign exchange market. At the same time, a lot does not always have the same value, but can take on different orders of magnitude in Forex trading. The standard lot is usually 100,000 units of a particular base currency. This is the most common lot and is used in most trades. There is also an option to purchase a mini lot. In this case, one receives 10,000 units of the respective base currency, although a mini-lot can also take on other orders of magnitude. In case of special requests, this can be renegotiated according to the capital volume. With a Micro-Lot, only 1,000 units of the respective currency are purchased. A micro-lot is therefore primarily suitable as an entry point for new traders, because here the invested capital also remains relatively manageable. The smallest unit is the Nano-Lot. This comprises only 100 units. As a rule, a nano lot is only used for very uncertain transactions or in situations where the return is particularly high due to the exchange rate, even with smaller amounts. Higher lots can also be purchased in case of lack of equity by using an appropriate leverage. Basically, more lots can be purchased than the amount of equity available.