The difference between Forex and other investments boils down to leverage. Leverage can be as high as 400:1 and in most cases you get to decide the amount of leverage and K Factor you want in order to prosper at Forex trading. Here is how.
Super high leverage is a selling point for many online forex brokers. How many times have you seen the tout controlling $100,000 of euro for $250? Those numbers are correct and the profit yields of super high leverage can simply be compelling.
I neither encourage nor discourage trading at super high leverage. The decision boils down to you. But unless you have a clear understanding of leverage implications, your chances of succeeding are slim. It is a cruel fact but it is better for me to tell you this rather than fabricating beautiful lies like most so-called experts.
The most fundamental term is PIP. Most XYZ brokers charge around 3 PIP per deal. Each currency pair has an average daily range of 100 PIP. We all know that the PIP has a variable value that differs with each currency pair. But are you aware that each PIP value also varies with base currency and gearing on your account?
For example, with EUR/USD at 1.2723 and leverage at 100:1, each PIP amounts around $7.86. At 200:1 leverage, it could double to $15.72. For traders with different gearing, a 100 PIP move means entirely different things to their account equity.
Here is a new way to look at leverage with the K Factor. The 3 most common leverage ratios available from online forex brokers are 50:1, 100:1 and 200:1. The K Factor is 2 for 200:1 leverage ratio, 1 for 100:1, and 50 for 50:1.
So how can you use it to your advantage?
There are basically 3 ways to do so.
1. Value Of PIP For Currency Pair You Trade
The first is using the K Factor to calculate the value of a PIP for the currency pair you are trading.
Since 100,000 individual currency units - usually dollars or euros - is the normal size of a single lot, you can calculate the value of a PIP with this formula:
(100,000/current price with no decimal) x K Factor = PIP
Here is an example: The EUR/USD current price is 1.2723 and your leverage is 100:1. With these facts the formula is:
(100000/12723) * 1 = 7.86.
The value of a PIP is $7.86. If your forex broker executes your trade at a spread of 4 PIPs, you are paying $31.44 whatever euphemism the broker is using for his commission. If your leverage or gearing is 200:1, that execution will cost you $62.88.
2. Determine Potential Profit
The second way you can use PIP and the K Factor is to quickly determine the potential profit in a trade or to know the extent of actual dollar risk in a stop-loss setting.
For example, if you go long the EUR/USD at 1.2723 and anticipate a move to 1.2850, what profit can you anticipate at 100:1 gearing?
12850 - 12723 = 127 PIP x 7.86 = $998.22 - execution cost.
If you objectively set your stop loss at 1.2715 what amount are you risking in this trade?
12723 - 12715 = 8 PIP x 7.86 = $62.88 + execution cost.
3. Kill But Do Not Dismember Strategy
The third way to use the K Factor is to avoid what the forex brokers call the safety net. But I call it Kill But Do Not Dismember Strategy.
Margin is not a down payment. It is your cash which the broker uses to protect his own capital account from your mistakes. That is all well and good because the global market will continue to work only if all participating brokers have adequate capital to meet their customers' settlement obligations.
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