Mathematics of pip production

When getting started in forex, it is useful to know how potential income is related to the amount of money in the account, the pips produced and the leverage used. The dollar amount of your account is your stake and will dictate how you trade. A pip, also called a point, is the smallest price increment a currency can make. “Pips produced” refers to the total net of profitable pips per month in our examples. The term many people get confused is leverage.

Here is how leverage works. A trader starting with $5,000 in his trading account can put on a currency position with an underlying value of more than $5,000. Some firms allow traders to trade 100:1 leverage. That means a trader with a $5,000 account could put on a long or short position with an underlying value of $500,000.

For every $10,000, a pip move is fixed at $1 in the EUR/USD, USD/CHF, AUD/USD and the NZD/USD. This means that a gain of 20 pips on a trade generates a profit of $20 based on $10,000 (also known as one mini-lot trade) position. But the same trade results in a $200 profit if the trader puts on a $100,000 position (known as a full-sized lot trade). The great appeal of forex is the ability to put on trades of large amounts instantly with less money.

But this type of leverage is a double-edged sword. When a trade works, it’s a fast way to a high income. When a trade doesn’t work, the risk of ruin can be real. Let’s look at some examples.

Consider a trader opening an account with $5,000 with a goal of $2,000 in profits per month. How realistic is this goal? The answer depends on the leverage used. Using 2:1 leverage a trader would be putting on a $10,000 position every trade. At this low-leverage level the number of pips produced would have to be 2,000 pips to achieve $2,000 per month. This is delusional and leverage would need to be increased immediately after any drawdown to trade just the mini lot.

Let’s change the scenario. Let’s have the trader achieve 400 pips per month and step up the leverage to 3:1. This means the trader would need to put on the average trade of $15,000 (a level of 1.5 mini-lots per trade).

It would be wise to use a pip production calculator, which generates projected income based on various account sizes and leverage, (see “Do the math”).

Consider a different scenario where the trader starts with the same $5,000 per month but also reinvests $500 of profits per month in trading. Using the same 3:1 leverage and a 400-pip production level, the result is $875 per month in expected income. By reinvesting $500 per month for three months in a row, if expected profits are met, by the fourth month the trader has accumulated an additional $1,000 per month he can reinvest, if expected profits are met.

Let’s examine a larger account size with smaller leverage and a production of 350 pips per month. With $20,000 in the account, using leverage of 5:1, the trader will be placing ticket sizes of $100,000, or one big lot. His income will be $3,500 per month. What is interesting is that the production of 16.2 pips per day is entirely feasible.

The bottom line is that forex trading is about pip production.

But achieving income goals is about leverage and account size. It is a precarious balancing act. The path to pip production is different for everyone because all traders have unique combinations of goals, means and ability. The best approach is an evolutionary one. Getting started in forex trading begins with finding out what kind of pip producer you are, but your first 20 trades should be done at low leverage.

In other words, if you have a $10,000 account, the first 20 trades should use no leverage. This results in the ability to learn from mistakes and survive them. Trading mini lots ($10,000) with no leverage generates a $1 per pip move. A 100-pip loss would represent a 1% drawdown. The same pip move of the typical $100,000 per trade, in the same account, would mean a $1,000 loss (10%) for one trade. Once a trading style is developed the trader will be able gauge the appropriate amount of leverage to use. The best way to achieve long term success is to start at a low leverage and test your skills.

Note: The pip production calculator is available for free by contacting the author.

Abe Cofnas is president of www.learn4x.com LLC and author of The Forex Trading Course: A Self-Study Guide To Becoming a Successful Currency Trader (Wiley Trading). E-mail: learn4x@earthlink.net.