In this lesson, you’ll learn:
- What margin is and its role in risk management
- The role of volume in trading and managing the risk
- How to calculate the value of a single pip
One of the first decisions you’ll need to make as a trader when beginning your trading journey is choosing a trading volume you can apply to your positions. It’s one thing to identify trends and spot trading opportunities. But how much money are you using for each position?
The choice of trading volume will depend on many psychological factors such as emotional comfort and risk aversion, but the choice of trading volume will also be highly connected with the risk management that you plan to apply. In other words, understanding how the trading volume may affect you is crucial, because the volume you choose will determine both the margin per trade and the value of the pip.
Margin
When opening a trade, you will need a certain amount of outlay. This is known as margin. The margin is not a cost but is an amount of money that is frozen when you open a position and is returned to you once the transaction has been closed. It is important to know what amount the margin will be so you can evaluate not only the risk itself but also calculate whether the remaining funds will allow you to open additional positions.
Remember that with CFDs, you only need a fraction of the nominal value to be able to open a position. For example with a leverage of 1:200 you’d only need 0.5% of the nominal value for the margin of the transaction. A typical leverage is 1 to 100, which means that you’d only need 1% of the nominal value of the margin. That allows you to potentially generate a higher return on the invested capital, but also makes the risk greater, meaning that you may need to deposit additional funds to cover your position. You will also suffer greater losses if the position moves against you.
Let’s say you’d like to open a 1 lot transaction on GBP/USD with leverage of 1:100, but you don’t know what the nominal value per lot is for this instrument. This information can be found in the instrument specification table.
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On the GBP/USD, the nominal value per lot is £100,000. If the leverage is 1:100, you will only need 1% for the margin of this trade, calculated in the base currency of the pair. Therefore, you need £1000 for the margin of a 1 lot transaction.
From a risk management point of view, margin is very important and the general notion applies that traders should not enter trades with a margin higher than 30% of the total invested capital.
Going back to the example above, if your initial capital is £5,000 and you would like to open a 1 lot transaction, then that would represent 10% of your total capital because the required margin with a 1:100 leverage would be £1000. It’s important that before opening a trade, you assess what your maximum margin will be, and not break any rules that you set for yourself. Following a strict risk management rulebook is very important if you are to achieve success on financial markets.
Pip Value
The second factor that the volume size will influence is the pip value. In the investment process it is very important to know the pip value, especially for risk management purposes. You should know how your portfolio will be affected if the market goes 100 pips in your favour, or 100 pips against you.
In order to calculate the pip value, you can use the instrument specification table again.
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In order to calculate the pip value per 1 lot you multiply the “Nominal Value of one lot” by the “Size of one PIP” and the value will be in the quoted currency:
100000 x 0.0001 = 10 USD
This means that if you open a 1 lot transaction on the GBP/USD and the market moves 100 pips in your favour, you would make a profit of $1,000 (10 USD x 100 pips). On the other hand, if the market does not move in your favour, you would generate a loss of $1,000. This calculation will help you evaluate on which market level your maximum accepted loss could be, and where you can possibly assign a Stop Loss order.
The general idea is that you should not risk more than 5% of your total capital in a position. The reason for this is that trading is based on probability and you should give your strategy a chance of assessment, to identify whether you have a bigger probability of achieving success rather than defeat.
You open a 1 lot transaction on GBP/USD with a pip value of £10. You will also the follow the rule of not accepting a loss higher than 5% of your total capital. Therefore, your total capital is £5,000 so your maximum accepted loss is £250, which is approximately $380.
If you know that 1 pip is worth $10 and your maximum accepted loss adds up to $380, then by dividing $380 by 10, your maximum Stop Loss level is 38 pips.
Manage the risk properly
As shown above, both pip value and margin play an important role in trading. Choosing an optimal size of your trading position is a vital part of trading, as it can make it easier or harder to manage your position after a trade is opened. What’s more, pip value and margin are also important from the risk point of view. If your trade is too big, a minor move can take you out. That is why you have to understand both of them to help you trade responsibly and to potentially increase your chances of trading successfully.
