Lesson 14 – Understanding Lots for Forex Traders
One of the most crucial things you will need to understand when you start trading is lot sizes.
When you enter a position (either long or short), you choose to buy a predetermined number of units (also known as pips). This number is known as the lot. The three most commonly used lot sizes in forex markets is seen below.
IMAGE SHOWING MICRO, MINI AND STANDARD and their respective unit numbers
Traditionally, forex was only traded in these lot sizes. But, nowadays since forex trading has become really popular and competition amongst brokers has become more intense, more lot size options have been added.
This increase in options and flexibility is great for traders like us.
Choosing a Lot size
When it comes to lot sizes, its best to think of their value in a currency like USD per pip.
Which basically means, by how much will the value of the lot change per smallest increment of change in the value of the currency quotation (remember a pip is a movement in price).
Most traders starting out won’t start trading in big lots unless they have a lot of trading capital. But even if you do have a lot of starting capital, it’s best to start to smaller sizes till you learn how everything works and you have a good trading strategy.
What’s great is that most brokerages let you choose the lot size that you want so that you can set your own level of risk and exposure.
A standard lot (often called just “one lot”) is 100,000 units of the base currency and will be the benchmark lot that we will work with when discussing trades in this course.
Using GBP, if we trade with one lot (100,000 units) then each pip will be worth $10.
Here are some examples of lot sizes and what one pip value would mean.
- 10 lot = £100 per pip
- 2.5 lot = £25 per pip
- 1 lot = £10 per pip
- 0.5 lot = £5 per pip
- 0.1 lot = £1 per pip
- 0.05 lot= £0.5 per pip
How important is it to choose the correct lot sizes?
It is really crucial that you choose the correct lot size when you engage in forex trading.
If you want to trade successfully then you must pay attention to the lot sizes you choose.
The size of the lot you buy/sell determines how exposed your account is to market fluctuations.
The larger the size of the lot, the more each pip movement will affect your account balance.
If your lot size is too big, then you will be overexposed and you will face a big risk to your account balance if things go wrong and the pips don’t move the way you want them to.
As a beginner who is starting out, it’s extremely easy to become overconfident and trade with lot sizes that are way too high, thus overexposing yourself and destroying your account balance before you even know it.
Trading success is a long marathon that takes discipline and consistency. It’s not a sprint to make quick money.
Here’s some example of how pip movements would affect your trading account if we traded one standard lot (100,000 units).
TABLE SHOWING DIFFERENT PIP MOVEMENT SIZES AND THE ASSOCIATED PROFIT LOSS
Managing risk with lot sizes
A lot of people believe this to actually be the most important point to consider and master in order to become a successful trader and protect yourself from destroying your account balance.
Of course, you may make mistakes from time to time, which is alright. Not every profitable trader has a 100% success rate, but what they do have is effective risk management and optimal lot-sizing.
Please make sure you understand this point above all else when it comes to forex trading.
Of course, while risk management will help protect you from overexposing yourself and destroying your account, it will also protect you from being too cautious.
Risk management will ensure that you succeed. Even if you have an excellent forex strategy, poor risk management will quickly lead your trading to become very unprofitable.
Now, onto our advice for managing risk
Recommended lot sizes
Generally, it’s pretty straightforward to figure a decent lot size in relation to your account size. This is what we recommend as a general rule of thumb.
For every £1,000 you should trade with a 0.1 lot size.
TABLE SHOWING ACCOUNT BALANCE AND ASSOICATED LOT SIZES ACCORING TO PREVIOUS RULE
So why do we recommend this rule?
Let’s say you’re starting with an account balance of £1,000 and you choose to trade with a 1.0 lot.
First, as mentioned earlier, when you have 1 lot, the pip value is £10. And since we know that a currency pair can on average move 100 points in one day. This is what happens if it moves 100 pips down:
£10 x -100 pips = -£1,000
Therefore, if you engage in such a big trade without a stop loss and it doesn’t go your way, you’ll destroy your starting account of £1000 to £0 in one go.
As long as you keep to the rules and table suggestions earlier, then the chance of you wiping out your account balance will reduce by a lot.
So, continuing off our previous example, if we had $1000 as our account balance, then we would recommend that you trade with a 0.1 lot size with a pip value of £1. Now if we take the same bad case scenario as before, where things went down by 100 pips, this happens:
£1 x -100 pips = -£100
So in this same scenario, we’ve prevented 90% of our potential losses. Now to empty your account to £0, you would have to lose 10 of those exact trades consecutively. Which is very unlikely, even if you have bad luck on your side.
You might immediately think that even though this reduces my losses, it would also reduce my profits, won’t it?
This is absolutely true, but you’re missing one more thing. Account preservation and keeping your capital alive is one of the most important things you need to prioritize as a trader.
You can’t keep trading if you don’t have any money in your account to trade with. So make sure to not destroy it.
Please make sure to follow these rules when you make any trade, with no exceptions. It’s absolutely necessary that you follow it to keep your account alive so you can keep continuing to make profits in the long run.
Coming Up Next
In chapter 5, we’ll continue to look at risk management more in-depth by showing you skills and strategies you can use to reduce your risk even more.
But for now, join us in the next lesson in understanding the market, titled “Lesson 15 – Forex Terminology, A Guide”.