What Are “Lots” in Forex Trading?
The decision to take a trade in the Forex market should be the result of a due diligence process that must consider various factors. Knowing where the market will go is not enough to make a profit from Forex trading. There are only two directions to choose from before taking a trade: long or short. If the trader thinks the market is moving up, a long trade should be taken; if not, a short one. That’s it! and nothing else regarding the potential future direction. Both fundamental and technical analysis are helping traders to find the direction of a currency pair, or the future move it is about to make. Is this enough, though? Are there any other factors to consider for the trade to be profitable? And if there are, how do we interpret them? The right answer is that knowing the direction alone is not enough. One might be right about the direction the market is going in, and still lose money on a constant basis. Let me give you an example using the Elliott Waves theory (we’re going to have a bunch of articles dedicated to it later in the Trading Academy), about how it is possible to lose money even if you know the general direction the market is moving in. The timeframe used is usually the reason for the wrong interpretation of an outcome. Greed and fear play tricks on us, and they either make traders take unnecessary risks such as overtrading, or close positions too early due to fear of being stopped out or losing the trading account. In both cases, the volume traded holds the key to avoiding losing your account or avoiding overtrading. In terms of the Forex market, volume equals lots.
Volume is expressed in lots, so the number of lots one trades is directly proportional to the risk associated with that trade. The bigger the volume traded, the bigger the risk, but also the bigger the potential reward. Traders therefore need to find the right balance between the volume to be traded, or the lots number, and the size of the account. Balancing these two is part of a sound money management system that should be followed by all traders, no matter what the financial product being traded.
A standard lot in the Forex industry is the equivalent of $10/pip (if the trading account is denominated in USD) for the EUR/USD pair. For more about what a pip is, please refer to one of the previous articles here on the Trading Academy, as we’ve covered that subject in detail. So, if one lot is traded on the EUR/USD pair and the pair moves in your favour by 10 pips, a profit of $100 is realised, before any other expenses in that trading account (commissions, spreads, swaps, etc.). On the other hand, if the trade goes against the desired direction, the loss is $100. The image below shows one lot sold for the EUR/USD pair, on the market, right at the moment this article was written. Consider that this is a demo account and that the potential gain or loss is virtual.
A simple look at the balance and equity of the account is telling us that trading one lot on an account of this size is not wise. It means that if the EUR/USD pair is moving against the trade for 100 pips – namely if it moves to 1.0818 – the trading account takes a $1,000 hit. This is more than 10 percent of only one trade, and it means one thing: the account is overtraded. Again, the thing to do is to find the right balance between the size of the trading account and the volume that is traded. As mentioned in the previous articles, it is not possible to have only winning trades, as that is not a realistic expectation when trading Forex. The idea is to have more winners than losers, and for the account to grow over time. Moves of 100 pips, or even a few hundred pips, can happen in the blink of an eye, and this means that to trade one standard lot, the account size should be bigger than the one illustrated here. After all, it is only logic.
Forex brokers that offer traders access to the market know that not all retail traders can deposit large funds in a trading account, and usually the amounts deposited are quite small. It is therefore not possible to trade one standard lot, and so the need for a new product appeared. This new product consists of offering retail traders the possibility of trading fractional lots. What is a fractional lot? This represents a trading volume smaller than one standard lot, and it is offered by all brokers these days.
As can be seen in the image above, below the one standard lot there are fractional lots or quantities available to trade, such as 0.12, and so on. Those are only default ones, but traders can pick 0.25 or 0.33 or whatever the single-digit number can be. In this way, trading with a smaller account is not that risky anymore, and money management techniques can be applied to small trading accounts as well. The chances of surviving in the ever-changing Forex environment just got bigger!
Believe it or not, but for Forex brokers quantity is better than quality. Brokers are competing to attract more and more new customers and convince them to trade with them, and for that, they need to offer conditions to attract them. After all, what is the difference between 10 customers who deposit $10,000 between them, and 100 customers who deposit 100 dollars each? The right answer is that there is no difference, only that the ones with small deposits cannot trade standard or fractional lots. To overcome that, micro-lots were invented. These are a further subdivision of fractional lots, and a typical volume for a micro-lot trade can be 0.05, or 0.01. This means that for every EUR/USD pip move on a 0.05 or 0.01 micro-lot trade, the trader loses or gains 50 cents or 10 cents. While the risk is lowered, the potential gains are lower as well. However, trading with micro-lots has multiple advantages, such as allowing traders to get the real feeling behind a live trading account, which, with perseverance, can grow in time. The purpose of this article is to show the importance of the volume traded, and this is measured in lots, or subdivisions of lots. Volume has a say in the size of the commissions to be paid as well, and all of these details, while they look like being insignificant, matter for the overall trading strategy. Traders should use different volume sizes based on the funds available in the trading account if they are to stand a chance against Forex volatility. For that, adjusting the lot size is key.
Recommended Further Readings
- Why Trading with a Regulated Forex Broker?
– What is regulation for a brokerage house, why it is important, things to look for, how to check if the broker is telling the truth, etc.
- Benefits of Mobile Forex Trading
– Pros and Cons of mobile trading, highlighting the net benefits of it.
- Explaining Commissions in Forex Trading
– What type of Forex trading accounts are subject to paying commissions, what does it means and is this a good or a bad thing?
- Opening a Live Trading Account
– Steps to open a live trading account with a Forex broker, starting with the time taken for the whole process, documentation to be sent, verification process, trading platforms to download, etc.
- Why Trading with a Regulated Forex Broker?
Other Educational Materials
- ANN for FOREX forecasting and trading. Czekalski, P., Niezabitowski, M. and Styblinski, R., 2015, May. In Control Systems and Computer Science (CSCS), 2015 20th International Conference on (pp. 322-328). IEEE.
- “Comparative study of FOREX trading systems built with SVR+ GHSOM and genetic algorithms optimization of technical indicators.” de Brito, Rodrigo FB, and Adriano LI Oliveira. In Tools with Artificial Intelligence (ICTAI), 2012 IEEE 24th International Conference on, vol. 1, pp. 351-358. IEEE, 2012.