A pip is the only way that forex traders can truly understand how the price of a currency pair has fluctuated within small time periods, such as seconds, minutes, and hours. For day traders, understanding exactly how pips work and what it is they are telling you is a basic prerequisite for trading success.
Although it might seem complicated at first, pips are actually designed to make the business of forex trading easier to understand. Read on for this essential beginner’s guide on everything you need to know about pips.
What is a Pip?
Pip stands for “percentage in point” (or “price interest point”, depending on who you ask). Put simply, a pip is a unit of measurement that denotes the smallest possible price move that an exchange rate can actually make. It is the very last decimal point on a price quote for a given currency pair.
The majority of forex pairs are priced to four decimal places, with the actual “pip” representing the fourth and final decimal point in that price. This means that, in these cases, a pip is the same as 1% of 1% (one “basis point”) of a currency pair’s given price.
For example, the smallest price fluctuation the USD/AUD currency pair can possibly make is $0.0001 – this is one pip basis point. However, it is important to note that not all currency pairs are priced in four decimal places. For example, USD/JPY is always conventionally priced at two decimal places, or at $0.01. This is a rare exception to the rule, but others do exist.
The value of the pip determines how much money is made or lost from each trade. This is because each currency pair will have its own pip value, which is calculated via several factors that we will discuss below. If you have a large position in forex trading, the fluctuation of even a single pip can therefore translate to huge profits and losses in an instant. Let’s dive in and explain how pips work in more detail.
The difference between a Pip and a Pipette
While the “four and two” model of pips is the global standard that dominates conventional currency markets, this is not the whole story. Increasingly, many forex brokers offer their traders “pipettes”. As the name suggests, these are smaller, fractional pips that break down currency pair price fluctuations even further.
Most pipettes simply go one step further, transforming a four decimal place price into a five decimal place price. Likewise, a two-decimal place price on USD/JPY will become a three-decimal place price once a pipette is added. For example, if GBP/USD is trading at 1.3876 and moves up to 1.3877, it has moved one pip higher.
However, if a pipette is added, an extra layer of detail is added. To move one pipette higher, USD/GBP would perhaps move from 1.38768 to 1.38769. It is a fractional pip that represents one-tenth of a “normal” pip. Many brokers offer pipettes as a means of offering additional ways to trade and profit, especially on currency pairs that are not particularly volatile.
How to Use Pips in Forex Trading
Pips are simply a way that traders can reference changes in the prices of currency pairs and therefore reference profits and losses. They are a standardised, simplified way to measure the exact and minute price fluctuations that currency pairs undergo on a minute-by-minute basis.
As a forex trader, it is likely that you will be relying on day trading strategies in order to make profits from incremental inter-day price changes in a given currency pair. Given that, during a single trading day, the price of currency does not typically change by a huge amount, pips allow forex traders to break those small changes down and make large profits from tiny changes.
Many forex trades, especially those using leverage, can involve significant positions, in which a price change of just one or two pips can translate to thousands of dollars’ worth of pure profit. Let’s take a look at an example. Assuming a forex trader has hit BUY on EUR/USD with the intention of making a profit, should the value of the Euro increase against the Dollar.
In the morning, the trader might have bought into EUR/USD at 1.1735. After a day of trading, EUR/USD may have risen to 1.801, at which point the trader would hit SELL and exit the trade. They would have made a profit of 66 pips on the trade, which could translate to huge gains, depending on the amount invested in EUR/USD at the beginning of the day.
How Pips Work
Pips are not only a way of breaking down price movements in a currency pair. They also denote how much you will pay for various currencies and how much you stand to make or lose from price movements. Let’s take a look at a popular currency pair to better illustrate what we mean here.
EUR/USD, for example, is one of the world’s premier major currency pairs, one that represents a huge chunk of daily forex trades. The Euro, which is the first currency in this pair, is the base currency. The Dollar, meanwhile, is the quote currency.
Let’s assume EUR/USD is trading at 1.1300 and that you want to hit BUY for 100,000 currency units. This would cost you USD $113,000, for which you would get €100,000 EUR. If this currency pair moved just one pip point higher, you would be able to hit BUY and made a substantial profit.
This becomes possible when trading on margin. In order to determine the exact value of each pip to you, all you need to do is run some very basic maths. Let’s break this down.
How to Calculate a Pip
If you want to determine the value of a pip in a given currency pair, all you need to do divide one pip (i.e. 0.0001) by the exchange rate at the exact moment, and then multiply that figure by the notional amount of the trade you are making. Let’s walk through an example to give a better idea of what it means to calculate the value of a pip.
Let’s assume EUR/GBP has opened at 0.8685 and closed at 0.8714, or 29 pips higher. Let’s also assume that a trader invested $350,000 in the pair at opening. In this case, the number of GBP invested per pip would be 350,000 x 0.0001, or 35 per pip. The per pip value would, therefore, be 35/0.8714, equal to EUR €40.17 per pip. Therefore, the 29-pip gain would translate to a profit of EUR €1,164.93.
Pips and Profitability
As you have probably seen from these examples, making a profit from smaller increases and decreases in pips requires significant investments. Of course, the vast majority of traders do not actually stump up hundreds of thousands of dollars on currency pair trades. Rather, they are granted margins from their forex brokers, which allows them to open up huge trading positions with only a fraction of the cash used as leverage.
While this is a potentially powerful way to increase your profits, trading on margin can also greatly amplify your losses. This is why it is essential to fully understand the risks that come with margin trading. Given that currency pairs only move in small and incremental amounts every single day, a large investment is required by those wishing to make significant profits within a short period of time. This is where pips come in handy.
Always Use a Trustworthy Forex Broker
When trading forex, you need a forex broker that you can trust and can offer you the pips that you want. For this, it pays to do your research. Fortunately, we have got you covered. At our expert forex broker review pages, you can find out everything you need to know about all of the biggest forex trading platforms around today.