What is a trading lot?
Such thing as a “lot” plays important role in activity of any trader. In this article, we’ll discuss the term “trading lot” on Forex and describe the ways to calculate it.
A lot is a volume of an operation on the Fore market, which is defined by global standards. 1 lot always equals to 100,000 units of a base currency.
For example, in case of USD/CAD, 1 lot is 100,000 USD, because the base currency of this pair is the American Dollar. If one takes such instrument as EUR/USD, then one lot equals to 100,000 EUR or, translated at the current exchange rate, 137,000 USD (EUR/USD rate is 1.3700, hence 1 lot equals to 100 000 * 1.3700).
To open a position of 1 lot worth 100,000 USD, one requires quite a lot of money on their account or the leverage, that’s why financial operations with such amounts of money are mostly performed by large funds and different financial institutions. As for retail speculators with relatively small deposits, brokerage companies provides them with an opportunity to trade fractional lots.
For standard USD accounts:
- Standard lot (full-sized) – 100,000 unit of a pair base currency; the volume is defined as 1.
- Mini lot – 10,000 units, defined as 0.1.
- Micro lot – 1,000 units, defined as 0.01.
For cent accounts:
- The same, but everything is in cents.
Since al operations on the interbank Forex market are performed with full-sized lots, brokerage companies that work with retail clients automatically accumulate fractional lots into a pool and place them on the market in total. This approach allows any trader to perform operations with currencies regardless of the amount of money they have.
How to calculate a lot on Forex?
When opening a position, a trader needs to calculate the optimal volume, i.e. the quantity in lots, which will allow the trader’s deposit to remain stable in case of any fluctuations against the open position. The order shouldn’t be closed by Stop Out even in case of the slightest price pullback.
First of all, to calculate the volume of a position to be opened, one must decide on two major components:
- The amount of maximum permissible risk for one position to be opened.
- Stop Loss level in pips from the entry point.
In addition to that, the following factors are used for calculations:
- The deposit amount.
- The cost of 1 pip of the price when using standard lots.
There are several methods of calculating the optimal lot size on the Forex market, and we’ll review three of them. In our examples, we’re going to use the following parameters:
- Deposit is 2,000 USD.
- Currency pair is GBP/USD (the cost of 1 pip in case of 1 lot order is 10 USD).
- Maximum permissible risk for 1 transaction is 3%.
- Stop Loss length is 100 pips (the distance between the entry point and Stop Loss level).
- The leverage value is 1:100.
Standard lot method
This method implies that the fixed lot size is specified just once and all further trading operations are performed with this particular value. When using this methods, one should take into account that:
- In case the lot size significantly increases, risks and possible losses increase as well.
- In case the lot size significantly decreases, efficiency of using your funds decreases as well.
In such a case, the recommended size volume for our example shouldn’t exceed 10% of the highest possible. The maximum lot for this currency pair is 1.2, which means that the fixed lot shouldn’t be more than 0.12.
Calculations are as follows:
2,000 USD * 100 (the leverage value) = 200,000 USD (money for performing trading operations in USD).
200,000 USD / 164,190 USD (100,000 GBP at the current USD rate of 1.6419) = 1.21 (the maximum possible volume in lots).
1.21 * 10% = 0.12.
Calculations based on the fixed exposure
The lot size is calculated based on the maximum exposure for 1 transaction. When opening an order, one specifies the position volume, in case of which possible losses will not exceed the set value. For this purpose, one calculates the exposure, which is 60 USD in our example. Then one should specify the number of pips to Stop Loss, 100, which means that the maximum cost of 100 pips shouldn’t exceed 60 USD. The lot size should be calculated in such a manner that the total amount of incurred losses doesn’t exceed the exposure. This method of calculation will allow to maximize profit with aggressive loss limits.
2,000 USD * 3% = 60 USD (the maximum exposure).
60 USD / 100 (pips) = 0.6 USD (the maximum cost of 1 pip).
0.6 USD / 10 USD (the cost of 1 pip of the full-sized lot) = 0.06 (the maximum lot size with at given loss limits).
Also, in this case one should take into account any changes in the deposit amount, hence to adjust calculations based on the current account balance. If the deposit increased up to 2,500 USD, then the maximum exposure will be 75 USD (2,500 USD * 3%), so the lot size will be equal to 0.07. In case the deposit drops down to 1,800 USD, the maximum exposure will be 54 USD and the lot size – 0.05.
Calculations based on the margin level and the deposit usage
This method is based on the idea that the maximum deposit usage can’t be more than 15%. According to the parameters of our example, we can open new positions as long as the margin is less than 300 USD.
In this case, the volume of the position opened in GBP/USD can’t exceed 30, 000 USD and the maximum lot size will be 0.18.
2,000 USD * 15% (the deposit usage) = 300 USD (the maximum margin in USD).
300 USD * 100 (the leverage value) = 30,000 USD (the position volume considering the leverage).
30,000 USD / 16, 190 USD (100,000 GBP at the current USD rate of 1.6419) = 0.18 ((the maximum possible volume in lots).
These example show quite simple ways to calculate the lot size on the Forex market when trading only one instrument. In reality, traders hardly ever trade only one instrument and open only one order.
That’s why calculations should be performed with allowance for the number of open positions and the total permissible exposure for the entire deposit.
And in the third example, one should distribute the margin between the number of open positions.
To smooth things down for traders, as well as avoid getting lost in details, you can always find different scripts for calculating the lot size in the Internet, which are run directly in the trading platform, or use an online calculators offered by brokers and other field-oriented companies.
Recommendations for beginners
It is critical for beginners not to overstate the volume of transactions, even if you are 100% sure of the result.
Below we will offer some useful tips that will help reduce the level of possible losses:
- During the calculation of the lot size, do not round the result up. Rounding should occur only to the smaller side. Example: when you got the value 0.728, with the correct rounding, your result will be 0.72.
- Test the selected trading strategy on historical data, which helps to determine the optimal average Stop Loss order value. This simplifies the calculation, since you no longer have to substitute new values. Only the size of the deposit and the level of risk will change, the rest of the data is known.
- When calculating Stop Loss levels, it is imperative to consider the size of the spread. If you place a stop order at 30, and the spread value is 2, then Stop Loss should be set at 32.