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The ABC of Forex Trading: Pips, Lot, Spread, Stop Loss, Take Profit, Long, Short

Do you wonder how to start trading in the Forex market? To effectively navigate such a dynamic environment, it is crucial to understand its basic terms and mechanisms. In today’s article, we will focus on explaining 7 fundamental concepts that form the foundation of every Forex transaction: pips, lot, spread, stop loss, take profit, long & short positions.

What is a Pips?

Pips (percentage in points) are the basic value by which the price of a given instrument can change. For most currency pairs, a pip is the 4th decimal place. Hence: 1 pip for EUR/USD = 0.0001. The exception is currency pairs involving the Japanese yen, where a pip is the second decimal place: 1 pip for USD/JPY = 0.01.

Pips are a crucial element that allows traders to measure changes in currency values and determine potential profit or loss from a transaction.

  • For example: if EUR/USD rises from 1.1200 to 1.1205, we say that the price has increased by 5 pips.

The Significance of Lot in Trading

Lot refers to the standard size of a transaction in the financial markets. A standard lot is 100,000 units of the base currency. However, for smaller transactions, there are also smaller lots: mini lots (10,000 units) and micro lots (1,000 units).

The size of a lot has a direct impact on the risk and profit in a transaction – a larger lot means higher risk, but also potentially higher profit.

  • For example: if you trade 1 micro lot (1,000 units of currency), a 1 pip movement in the EUR/USD pair will equal about $0.10 profit or loss.

What is Spread?

Spread is the difference between the buying price (bid) and the selling price (ask) of a currency. It is the basic transaction cost for traders.

  • For example: if the spread for EUR/USD is 2 pips, it means that the sell price is 2 pips higher than the buy price. A low spread is more favorable for traders, as it means lower transaction costs.

If you open and close a position on EUR/USD with a 2-pip spread, you need to overcome this spread to make a profit. This means the market must move at least 2 pips in your favor before you start earning.

Stop Loss and Take Profit – Key Risk Management Tools

Stop loss is an order that closes a transaction when the market reaches a specified price level, thus minimizing potential losses. It is an essential risk management tool that helps traders maintain discipline and protects their capital from uncontrolled losses.

If you buy EUR/USD at 1.1200 and set a stop loss at 1.1150, your maximum loss will be 50 pips per transaction. This allows for loss control, even if you cannot constantly monitor the market.

Take profit is an order that automatically closes a transaction when the market reaches a specified profit level. This allows a trader to realize a profit, even when not monitoring the market at that moment.

  • For example: suppose a trader trades the EUR/USD currency pair. The current price is 1.1200. The trader predicts an increase in the value of the euro against the dollar and decides to open a long position (buy) at this price. Expecting the rate to rise to 1.1250, they set a Take Profit order at this level. In such a scenario, even if after reaching 1.1250 the EUR/USD rate falls, the trader’s position is already closed with a profit, thanks to the Take Profit order.

Long and Short Positions

In the Forex market, there are two types of positions:

Long position (Buy) – taking a long position means buying a currency, stock, commodity, or another financial instrument in anticipation that its value will increase. 

  • For example: if a trader believes that the euro (EUR) will rise against the US dollar (USD), they may decide to purchase the EUR/USD currency pair. If the EUR/USD price increases, the trader can sell the pair at a higher price, making a profit.

Short position (Sell) – taking a short position means selling a currency, stock, commodity, or another financial instrument in anticipation that its value will decrease.

  • For example: if a trader predicts that the value of the USD will fall against the JPY, they may open a short position on the USD/JPY currency pair. If their predictions come true and the USD loses value against the JPY, they can buy back the pair at a lower price, making a profit.

Trading in the Forex market requires understanding terms such as pips, lot, spread, stop loss, take profit, and distinguishing between long and short positions. Each of these concepts plays a significant role in a trading strategy, helping traders manage risk and make informed investment decisions.