Understanding Forex Pips

Pips in Forex TradingIn forex trading, it is very important to have a crystal clear understanding of the pips concept. This is because it comes in handy when you deal with exchange rate price movements, calculating the profits you make or losses you incur on a position and managing risk in an effective manner. However, it is a fact that many traders do not know what forex pips are and how they can manage their risk when trading currencies. This often puts them at a disadvantage and, therefore, their performance as a forex trader suffers a great deal. The aim of this post is to provide you with some useful information about forex pips so that you have a better understanding of the concept and you are in a better position to succeed as a trader.

Forex Pips – What Are They

In forex, a pip is the smallest amount by which the price value of the currency pairs changes. In the case of most major forex pairs, except those that involve the Japanese yen, it represents the fourth decimal place of the exchange rate. As an example, consider the currency pair EUR/USD. If its exchange rate moves to 1.2065 from 1.2050, it indicates an increase of 15 pips. On the other hand, a move to 1.2025 from 1.2050 represents a drop of 25 pips.

Pips are defined differently for currency pairs that have Japanese yen in them. In such pairs, the second decimal place represents the pip. This is because they are generally quoted with 10 or higher exchange rate. For example, consider the USD/JPY currency pair and imagine that it is being currently quoted at 110.40. If the pair’s price rises to 110.90, it would represent an increase in the exchange rate of the USD by 50 pips against the yen. Now, if the exchange rate moves to 110.05 form 110.40, it means a decline of 35 pips.

Pipette

A fraction of a pip is referred to as a pipette and is valued at one-tenth of a pip. This means that the pipettes represent the fifth decimal place of the exchange price of currency pairs in which the yen is not involved. In the case of the currency pairs that involve the yen, it represents the third decimal place in their exchange prices.

The pipette assumes a lot of importance when you consider the spreads that the brokers offer. The spread refers to the difference between the ask (buying) and bid (selling) prices. Brokers often provide quotes, specifying 5 decimal places in currency exchange prices. This means that spreads are generally expressed in terms of pipettes. Typically, the spread for major pairs like the EUR/USD may be 0.7 pips (7 pipettes), while that for cross pairs like AUD/CAD may be around 2.2 pips (2 pips and 2 pipettes or 22 pipettes). As many brokers quote currency prices with up to five decimal places on their forex trading platforms, it is important to differentiate pips from pipettes quite early in your learning process.

The Volatility of Currency Pairs

The process of learning forex trading starts with understanding the concept of pips. This understanding is essential to learn other complicated concepts. One such concept is volatility. It is expressed in terms of the number of pips by which the prices of forex pairs move in a day. In general, cross pairs experience larger price movements than major forex pairs because of relatively low liquidity.

Liquidity has a key role to play as far as pip-volatility of currency pairs is concerned. This is because there will only be a smaller number of sellers and buyers at any point in time. This is why exotic currency pairs (forex example, Mexican peso/ Turkish lira) easily moves hundreds and thousands of pips during the course of a trading day.

As a forex trader, you must embrace volatile pairs. This is because volatility provides trading opportunities. Naturally, you should also protect yourselves by employing risk management strategies. However, it all begins with understanding pip in the right manner.

What Is a Pip Worth In Forex Trading ?

Many forex traders find it interesting to calculate the value of one pip. This is important to determine the total profit make or the loss you incur in a trade. The factors that impact the current pip-value of forex pairs include the currencies involved, position size, and the exchange rate.

The following table shows the effect of position size on pip-value:

Lot SizeUnits of Base CurrencyVolumePip Value (base: USD)
1 Standard Lot100,000 Units1.01 pip = $10
1 Mini Lot10,000 Units0.11 pip = $1
1 Micro Lot1,000 Units0.011 pip = $0.10
1 Nano lot100 Units0.0011 pip = $0.01

 

You can use the following formulas to calculate your profit or loss generated by your position with a great deal of precision.

Value of one pip or pip value = (0.0001/Exchange rate) X Position size

Total profit or loss = Pip value X Number of pips

As an example, imagine that you are trading a standard lot of the currency pair GBP/USD. Suppose you purchased the lot at 1.325 and closed your position at 1.3290, you would have earned 40 pips as profit. In order to calculate your profit, you need to first determine the pip value.

Value of one pip = (0.0001/1.3290) X 100,000 = 7.52 GBP

Therefore, the total profit = 40 pips X 7.52 GBP = 300.80 GBP

Final Thoughts

In this post, the concept of pip in forex trading and how you can apply it in determining your trade profit or loss have been explained in detail with examples. As you know by now, pip is the smallest denomination by which the value of a currency pair changes. Typically, it signifies the fourth decimal place of the currency exchange price wherein the Japanese yen is not involved. In the case of currency pairs that involve the yen, the second decimal place represents the pip. Pipette represents a pip’s fractional value. It has one-tenth the value of a normal pip.

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