Trading foreign currency can be rewarding. At the same time, it can be confusing, especially for beginners. You must be familiar with different terms and concepts. Among others, one thing you should learn about is lot size.
In a nutshell, a lot size is the size of your position or trade. It refers to the amount of currency you intend to buy or sell. In turn, it can impact your gains or losses. Read on to learn more about how it works.
What Lot Size Means in Forex Trading
A lot refers to the volume or quantity of trading in forex. They’re standard sizes for trading your chosen currency pairs.
Let’s make things easier. Consider you’re selling a pizza. One pizza has eight slices. You’re not selling per slice. Instead, you’re selling the whole pizza.
In the case of forex trading, you cannot buy a single unit. Rather, trading is done in lots. There are four types of lot sizes:
– Standard Lot: 100,000 units of currency
– Mini Lot: 10,000 units of currency
– Micro Lot: 1,000 units of currency
– Nano Lot: 100 units of currency
Now, let’s look at a more specific example. Let’s say you’re trading the EUR/USD currency pair. EUR is your base currency. On the other hand, USD is the quote currency.
If you’re trading a standard lot, you’ll need 100,000 units of the base currency (EUR). Then you’ll convert it to the quote currently depending on the existing exchange rate. For the purpose of this analogy, we’ll assume the value of one EUR is 1.09 USD.
100,000 x 1.09 = 109,000 USD
Based on the computation above, you’ll spend 109,000 USD to buy a standard lot of EUR.
Now, let’s say you intend to trade only a nano lot. Here’s how much you’ll be paying:
100 x 1.09 = 109 USD
It’s important to understand how leverage affects your lot size calculations. Through leverage, you can control a larger position with a smaller capital. However, you must be careful as it can also amplify your losses. For more in-depth insights on leverage trading, there are various sources on the internet.
How to Calculate Lot Size
The computation in the section above shows how much you’ll need to spend to buy based on your intended lot size. Below, however, our focus shifts to calculating the actual lot size.
1. Decide on Your Risk Tolerance: Investors can tolerate different levels of risk. Now, let’s assume you’re willing to risk 1% of your account balance for every trade. This risk appetite is a common recommendation.
2. Compute the Dollar Amount at Risk: You simply need to multiply your account balance by the percentage of your risk tolerance. If your balance is $10,000 and your risk tolerance percentage is 1%, then you’ll have a $100 risk per trade.
3. Determine Your Stop-Loss Level: Know when to exit the trade. This will prevent catastrophic losses. Your trading analysis and strategy will determine this level.
4. Calculate the Pip Value: A pip refers to the percentage in point. This is the smallest price movement in a currency pair. It indicates how much you’ll gain or lose for each pip that the price moves. For a standard lot, the pip value for most currency pairs is $10.
5. Find the Lot Size: Here’s a simple formula to do this:
Lot Size = Account Balance x Risk Percentage / Trade Risk in Pips x Pip Value
= $10,000 x 1% / 50 Pips x $10 = 0.2 Standard Lot
Using Technology
Fortunately, you do not need to calculate your lot size manually. Technology is your best friend if you hate crunching numbers. Many trading platforms include a built-in feature for automatically computing your lot size. You can customize values depending on a specific trade.
Further, you can use risk management software. It can analyze trading performance and understand patterns. Some will also allow you to test specific strategies based on historical data. As a result, you can adjust your lot size accordingly.
Adapting Lot Size to Your Trading Strategy
Scalping is one of the most common trading strategies. It involves making small trades during the day, taking advantage of profits from small price movements. In this strategy, larger lot sizes with a tight stop loss can work best.
For day trading, you’re opening and closing your position within the same day. This requires a moderate lot size. Further, it needs a careful balance of risk and rewards as you determine your stop-loss level.
Meanwhile, under swing trading, you’re holding your position for a longer duration. It can be several days to a few weeks. Smaller lot sizes with wider stop losses may be your best bet.
Conclusion
Overall, forex trading isn’t a simple guessing game. There’s science behind the numbers, and this is where lot sizes become relevant.
In a nutshell, a lot size is the volume or quantity of a given trade. It helps determine capital requirements while also letting you manage risks better. Knowing your lot size can also help you adjust your trading strategy.