What indeed is a forex lot? A lot in forex is used to describe the trade volume or a trade size in numerical terms as opposed to the financial terms used to describe the size of a trader’s position.
The benchmark in describing a forex lot is usually the Standard Lot, which has a value of 1.0 and is equivalent to a position size of $100,000 or 100,000 of the base currency in which a trader’s account is denominated. All further subdivisions and denominators in forex are usually made in reference to the Standard Lot. Hence, subdivisions of a forex lot into 1 decimal place (0.1 to 0.99) is known as a minilot, and subdivisions in the order of 1/100 are known as micro-lots (0.01 to 0.099 lots). Higher position sizes are classified as a function of the Standard Lot, so we speak of 2 Standard lots (2.0 lots), 300 Standard Lots (300.00), etc.
Financial Worth of Forex Lots
We have just described forex lots as a measure of the trade volume of a forex position. What is the financial value of a forex position depending on the lot size of that position?
- A Standard Lot is $10 per pip on most currency pairs. For a Yen cross, this is slightly less.
- A mini-lot (0.1 lots) is $1 per pip.
- A micro-lot (0.01 lots) is $0.1 per pip (i.e. 10 cents per pip)
The exact earnings or loss per pip can thus be calculated based on the exact lot size for the trade.
There are some forex platforms where the lot size of a trade is expressed in terms of financial value (1 Standard Lot – $100,000; 1 Mini-Lot – $10,000; 1 Micro-Lot – $1,000). For brokers that offer traders the MT4 platform, the lot size is expressed in decimals, using the Standard Lot (1.0 lots) as the benchmark.
Importance of Forex Lots
One of the greatest things a forex trader can do for his/her forex account is to understand how to use forex lots when setting positions in the forex market relative to account sizes.
Before deciding on the lot size to use for a forex position, it is important to first consider the account size. Experts have agreed universally that a trader’s market exposure should not be more than 5% at any point in time. So the forex lot size for the trade must be a reflection of this risk management rule. Let us use an example to demonstrate this. For this, we will use a trader named Chris, who has a $5,000 account and is looking to know what forex lot sizes he should use to keep his market exposure at 4%. He is looking at having a maximum of three simultaneous trades at any point in time, with a maximum stop loss of 50 pips per trade.
$5,000 in forex capital. Maximum exposure of 4% and a maximum of three trades open at the same time while sticking to the risk profile and setting 50 pips as stop loss per trade. How does Chris make this all work out?
4% of the $5000 account is $200. This means that even with three trades open, not more than $200 must be risked at any point in time. Let us assume Chris decides to trade with 0.1 lots on each of the three positions at a leverage of 1:100. Does it keep him within exposure limits?
50 pips stop loss is equivalent to $50 loss using a trade size of 0.1 lots. For the three trades, this is $150. This leaves room for Chris to do some manouvering. With $50 to spare until his maximum allowable risk of $200 or 4% of his account, he can decide to extend his stop loss level by 50 pips, splitting this between the three trades, or he can decide to increase the lot sizes as follows:
- Trade 1: 0.1 lots (value of stop loss is $50)
- Trade 2: 0.15 lots (value of stop loss is $75)
- Trade 3: 0.15 lots (value of stop loss is $75)
The combined stop loss value is $200, which is within the trade exposure limit.
Chris can also decide to get more ambitious with his lot sizes, but would have to sacrifice his stop loss settings to make them tighter. For example,
- Trade 1: 0.2 lots (value of stop loss = 40 pips or $80)
- Trade 2: 0.2 lots (value of stop loss = 40 pips or $80)
- Trade 3: 0.1 lots (value of stop loss = 40 pips or $40)
The combined stop loss value with these new settings is still $200, albeit with tighter stops. Chris will still be within the trade exposure limits.
From this example, we can see that the forex lot size, the Stop Loss as well as Take Profit targets are all interwoven and when a trader makes a decision on what lot size to use for a trade, a careful consideration of the risk-reward profile for the trade must be made. More risk assumed within the confines of the risk management profile will lead to the use of tighter stops, while lesser risk will allow a trader to use stops which will allow the trade to breathe.
One thing also jumps out immediately: accounts which are less than $2,500 in size make it very difficult to trade more than one position or to use lot sizes of greater than 0.1. For such traders, micro lot accounts are the way to go.
In conclusion, we can safely say that before a decision is made to go into the forex market, traders must use the forex lot factor as a means of determining the following:
- Choice of broker: Opening an account with $1000 with brokers who only offer mini-lot and standard lot accounts is a bad gamble. This will only lead the trader to assume excessive risk and it won’t be long before the trader is stopped out. In such cases, use a broker with facilities for micro-lots.
- An even better choice is to make sure that accounts are not underfunded. A good capital to start forex trading with is at least $5000. Remember that the same effort used in trading a $500 account is the same effort used in trading a $5000, with the difference being that the rewards on the better funded account are much more than the other.
- Always adjust your forex lot sizes and stop loss settings to match your account’s risk management profile.