Forex Lesson 5. How much in dollars?
When you analyze charts, you look at technical levels. You think about how many pips you can get in a trade. You can also see the profit or loss for your open position – that’s shown in your account currency.
Imagine you had a great day and earned 1000 points. How much is it in dollars? That depends.
Think of it as the preparation of a meal. The bigger quantity of an ingredient you add, the more portions you will have. The dollars are your ingredients, input or, if we choose to say, investment. The more you put at stake in a particular trade, the more you will get for profit. At the same time, your risks also increase: what if you choose the wrong temperature and ruin your dish? In this case, the smaller quantities of ingredients you had spent to cook, the more you will have left.
Yes. You can manage your input in a trade. To do that, choose your trade size in lots. The more lots you trade, the more will each pip/point of profit bring/cost in $.
Let’s see that on the example of EUR/USD.
If you open a 0.01 lot trade and your account is funded in USD, 1 point of profit will account for 1 cent.
If your account is funded in USD and you open a 1-lot trade, 1 point of profit will be $1 for you.
So, let’s get back to our 1000 points.
In the first case (trade volume = 0.01 lot), you will earn 1000*$0.01 = $10.
In the second case (trade volume = 1 lot), you will earn 1000*$1 = $1000.
Wow! That’s the difference!
Naturally, you will want a bigger gain. However, everything has to be balanced. What if you lose 1000 points? In this case, your loss will be either $10 or $1000. That got you thinking, right? Was it like a bucket of cold water?
Don’t worry, soon we will explain how to minimize possible losses and at the same time maximize your gains.
The most important thing is to manage your money. By doing so you control your risks and make sure that the amount you have invested in trading is of the greatest advantage to you.
Don’t put all your eggs in one basket!
That’s a saying, but it has a lot of wisdom. We’ll explain what it means.
You opened an account and put some money on it. The first thing you want is, of course, to spend it on trading, right?
Not so fast!
Billions of traders have already gathered some experience and developed a golden rule of trade volume.
A golden rule of trade volume: the optimal size of a single trade is 1-5% of your deposit.
In other words, if you want to spend $10 on a trade, you should have at least $200 on your account (in this case, $10 will be 5% of your account).
Let’s make it clear: obviously, the golden rule is not respected by all traders, but the disciplined, patient and cautious ones follow it accurately. Reckless traders don’t count money. Can you guess which traders keep and multiply their funds and which have their accounts blown out? Not all traders succeed and this is one of the main reasons why it happens. Your goal is to be among those who trade with profit. Now you know what to do!
The reason is simple. Imagine you used your entire account to open a trade. Something happened at the market and the trade went wrong. You are in complete shock and don’t have enough money to make another trade. Bad luck? Not exactly. It’s bad decision making more than anything else!
Now let’s consider another situation. When you risk 5% of your account, for example, $10 out of $200, you have enough money to open 20 trades. This means that if a trade goes badly, you will have many opportunities left to try other trade ideas.
Even if only half of these trades are successful, with the right risk management you can end up with the amount bigger than the initial $200. This means that you had profit!
The smallest trade volume you can choose is 0.01 lot. In monetary terms, that’s 1000 units of a base currency, usually 1000 USD or 1000 EUR. That’s not a small amount for a single trade. And if that’s only 1% or 5% of an account…
We have already explained that leverage allows you to borrow money from the broker in order to open trades of bigger sizes. It means that even to open a trade of the smallest volume (0.01 or $1000), you can use $10 or even $1 (with 1:100 leverage you’ll need $100 and with 1:1000 leverage you’ll need $1).
You can usually choose a leverage in the settings of your account in your personal area. Leverage determines what boost you can get from a broker. The bigger the leverage, the bigger the boost. In other words, the bigger the leverage, the smaller amount you will need to open a trade of the same size.
Which leverage to use?
From the first sight, the decision is obvious: choose the biggest leverage possible and invest only a little of your own in trading.
Again: not so fast! Always be aware that your risks also increase with leverage. If you open a buy trade but the price is going down, each point the price moves against you will bring you a bigger loss the bigger the leverage you are using is. As a result, you should be careful and choose a reasonable leverage size.
For beginners, 1:100 leverage is usually considered a good choice: it’s neither too big, nor too small.
We have come to the most interesting part! No doubt that you are eager to open many orders in your trading platform and you want to know what exactly to set in the ‘Volume’ field.
The idea is that you put several things together: the amount of money you set aside as the margin for the trade (here you use the golden rule of 1-5% of the account) and leverage (it will transform your margin into the actual and bigger trade size). This will allow you to see how many lots you can trade.
If you have $20 as the optimal size for a trade and use 1:1000 as a leverage, you will dispose of $20,000 for a trade. That’s 0.2 lots. Therefore, you can enter this in the ‘Volume’ field.
Some traders prefer using the same trade volume in lots for every trade. This is a very simple concept: once you have found a volume you are comfortable with, you just stick to it. This strategy is easy to implement for beginners because after the initial calculation you can stop thinking about the volume and just choose the same one every time. It should ensure the stable growth of your account.
It’s recommended to choose small trade sizes at first. Later, when you gain in experience and your account gets bigger, you may choose to increase your trade volume.
Example
You have $500 on your account. With the leverage of 1:1000, this amount will be enough to make 500 trades of 0.01 lot each, 50 trades of 0.1 lot each or 5 trades of 1 lot each. Another option is 25 trades of 0.2 lots each. Moreover, there are more options! If you manage your risks, your account will gradually increase.
If you follow the logic outlined above, you’ll be using the following formula:
Lots to trade = Equity * Risk % * Leverage / Contract Size
With $500 account and 5% risk that will be:
$500 * 0.05 * 1000 / 100,000=0.25
Equity means the value of an account if all positions were closed (i.e. it counts the profit/loss in your running trades).
It’s also possible to take into account the situation at the price chart and the size of a Stop Loss you need for your trade. Here’s how we adjust the formula:
Lots to trade = Equity * Risk % / (Stop Loss in Points * Point Value)
In this case, you know what SL you would like to have and you know how much you want each pip of the price action to bring you.
Example
You saw that the price has failed to get above 1.40000 and turned down. You opened a SELL trade at 1.39800 with a Stop Loss at the previous high at 1.40050 (SL = 250 points). Your Take Profit is at 1.39050.
If you need a Stop Loss of 250 points, you will trade $500 * 0.05 / (250 * $0.1) = 1 (or 0.1 lots). The outcome is in 0.1 lots because the point value used in the calculation ($0.1) was for a 0.1 lot.
The amount of money you need to start trading depends on the account type you choose.
For example, to trade on the micro account you will need to deposit at least $5. You will be able to open orders the volume of which starts from 0.01 lots and use decent leverage. If you plan to open many trades, consider a standard account with a 0.5-pip floating spread. This type of account requires a minimal investment of $100.
Remember the thing we’ve already learned:
Your deposit determines your trade size...
...so the trade size you want to have determines your deposit!
If you buy 0.01 lots of EUR/USD and your leverage is 1:1000, you will need $1 as a margin for the trade. If you deposited $5 on the micro account, your deposit will cover this margin and you will be able to open another four trades of this size. Each point of price movement will either bring you or cost you $0.01.
Let’s consider some good options for a beginner trader. The examples we bring here are safe and sound from the point of risk management.
Deposit = $100
The amount of risk for a single trade should be below 5%, no matter how big your deposit is. Let’s go with a 3% risk ($3 or $3000 with 1:1000 leverage). If you trade 0.01 lots, each point of price movement will equal $0.01. By dividing $3 by $0.01 we get 300 points. This is a Stop Loss you can afford having. This is more than enough for a trade you keep open for several hours. It’s recommended that your Take Profit exceeds your Stop Loss in about 3 times. Therefore, you will target 900 points ($9) as a profit in this trade.
True. This ratio $3/$9 is called a risk/reward ratio. This way one good trade ($9) will allow you to have three bad trades and lose nothing. Market analysis that we’ll study in the next lesson will help you reduce the number of bad trades and thus be in gain after a series of trades. This is the argument in favor of carefully setting trade volumes and having a correct risk/reward ratio.
Deposit = $500
What if your deposit is $500? With 3% risk ($15), your trade size can be 0.15 lots. In this case, each point of profit/loss will account for $0.15. With a bigger position size, you’ll be able to earn money faster! There will be 100 points for a Stop Loss. If you need a wider Stop, you can trade 0.1 lot: this will make each pip cost $0.1. Stop Loss will be 150 points. With 5% risk ($25), you can allow a 250-point SL. The profit in this case (if your Take Profit is 3 times bigger) will be $75.
Deposit = $1000
If your deposit is $1000, you, of course, will be capable of opening even bigger trades. The risk of 3% for a trade ($30) and 1:1000 leverage will allow you to trade 0.3 lots. The risk of 10% ($100) will allow you to trade 1 lot. In this case, 300 points of profit will account for a gain of $300. The optimal risk of $30 a trade will allow you to trade 0.1 lots with the SL of 300 points. The potential gain will be $90.
Another important thing: remember about Margin Calls and Stop Outs. Margin Call is an allowed margin level of 40% and lower. At this point, the company is entitled but not liable to close all open positions of a client due to the lack of free margin. Stop Out is a minimum allowed level of margin (20% and lower), at which the trading program will start to close client’s open positions one by one in order to prevent further losses that lead to negative balance (below $0).
If you abide by the rules of risk management and don’t put your entire deposit in trading at once, you’ll be safe from Margin Calls and Stop Outs.
Remember that there are demo accounts that allow you to practice trading without investing a single dollar. Or euro. Or whatever. The size of a demo account with FBS can be up to $1 million. The demo account will allow you to practice opening orders and setting position sizes. Use the amount you really plan to invest in trading. In this case, everything will be realistic and you will be able not only to practice trading, but also to get a model of how your account may change in size when you trade for real.
Lesson summary
- The bigger trade you open, the bigger will be the profit/loss for each point of price movement.
- The best solution from the risk management point is to limit the size of a single trade by 5% of an account.
- Leverage allows traders to open trades of bigger volume.
- Deposit and size of trade determine each other.
In the next lesson, you will learn how to analyze the market in order to get buy and sell trade ideas.
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