The word ‘lot’ may typically refer to a piece of land. However, did you know that it’s a fundamental concept in foreign exchange? Forex lot sizes matter for every trade and can dictate the way you enter the market.
You can read about this vital trading construct in this guide and how it works.
What does ‘lot’ refer to in forex?
In forex trading, you place a trade in the market by buying or selling currency. What you spend on the transaction is referred to as a lot.
A ‘lot’ in forex trading is the specific quantity of a currency sold or bought in a trade. This standardized unit of measurement signifies the volume or contract size of the currency exchange.
Forex lot sizes work similarly to other trading values in various asset classes. For instance, you can measure gold trades using ounces or kilograms, while petrol is traded in liters. In forex currency pairs, it isn’t viable to transact one unit—you need to buy or sell by lot.
Here’s an imagery: a donut brand sells products in boxes of two sizes, a dozen or two-dozen. When you buy these donuts, you can choose to buy a 12- or 24-piece box, depending on your preference. You likely won’t expect to purchase just one piece from the box.
That said, lots are a universally recognized volume or size for forex trading. There are four types of forex lot sizes that traders across the globe follow:
- Standard lot. The largest unit, a standard lot represents 100,000 units of the currency pair’s base currency. It is ideal for large trading accounts that can handle higher risks.
- Mini lot. Mini lots represent 10,000 base currency units, or one-tenth of the standard lot size. Retail traders who prefer smaller market positions can use it when trading. It is suitable for scalping strategies or multiple short-term trades.
- Micro lot. Smaller than mini a lot, the micro lot size is one-tenth of the former, which is equal to 1,000 units. Traders with limited capital or who want to test new strategies can trade using micro lots to avoid bleeding losses.
- Nano lot. A nano lot is equal to 100 units of the base currency and is one-tenth of the micro lot. It’s preferable for novice traders seeking to enter the market with minimal risk.
Why do forex lot sizes matter?
The risks you face when trading currency pairs depend on several factors, and that includes forex lot sizes. For instance, you could potentially lose more when using standard lots compared to micro lots.
The lot size impacts the value of a pip (the tiniest price movement of a currency pair). What type of lot you settle on can determine the profit or loss for each pip moving upwards or downwards.
There are two instances in which forex lots matter and why you should familiarize yourself with it. Firstly, it plays a role in account management. Trading account types may only offer specific lot sizes and require a minimum deposit. Knowing lot sizes can help brokers pick an account type that matches the investor’s risk tolerance and trading style.
Understanding forex lot sizes can also matter when choosing and implementing trading strategies. As mentioned earlier, a scalping strategy may work effectively using a smaller lot. On the other hand, long-term methods should ideally consider larger lot sizes.
How to choose between forex lot sizes
One of the most crucial decisions to make in forex trading is selecting the type of lot size. This value can dictate how much money you need to spend or the leverage you must use. It will also affect each pip movement—choosing large lots magnifies the cost of each pip movement.
Fortunately, you can decide based on several considerations other than your account size and market knowledge. Here is an overview of some of these factors.
Risk tolerance
Risk-averse traders may feel more comfortable trading with a small lot size. Doing so limits their exposure to the forex market. Conversely, people with a higher risk tolerance can opt for larger positions using a standard lot size.
Market conditions
You should evaluate current market conditions before choosing a lot size. For instance, a liquid market is ideal for keeping larger positions. If the market condition presents volatility, it’s wiser to use smaller forex lot sizes to mitigate risks.
Trading strategy
Lot sizes affect your trading strategy, but this correlation can also go the other way around. Your preferred trading method can influence your choice. If you prefer short-term trading such as day trading, a smaller lot size makes sense to use.
Trading platform
There are trading platforms that limit the availability of certain lot sizes for investors. Some may offer all four types of forex lot, while others allow only the larger options (standard and mini lots).
Forex leverage vs. lot size
To new forex traders, leverage and lot sizes can become confusing since they refer to a specific quantity. However, these concepts are different, although forex trading works when both go hand in hand.
Forex leverage refers to the amount borrowed from a broker to go with the amount you own. It lets you gain a bigger exposure to the forex market. This value is expressed in ratio format and enables you to trade large positions to magnify potential returns.
The best approach is to balance leverage versus lot size before making your move. For example, high leverage may get you closed out if used with only a micro lot account. Before diving into it, you should research how it works and improve your risk management skills to prevent bleeding losses.
Conclusion
Understanding forex lot sizes is a vital component in successful forex trading. This standardized unit of measurement signifies the investment you make in foreign exchange. You can choose a forex lot size based on your risk tolerance, strategies, and other factors to enhance potential returns.
As always, you should exercise caution and do your research before deciding on which trading position works for you. It’s good to trade within your capacity and keep learning about forex to keep you in the game longer.
