Pips are so important to FX trading that you should not start trading before you get a clear understanding of what they are.
Let’s briefly look at the following before expanding on pips:
|All major currency pairs are usually quoted to five decimal places||EUR/USD = 1.07339|
|Most non-major pairs are usually quoted to four decimal places||GBP/NZD = 1.9502|
|Japanese yen pairs are usually quoted to two or three decimal places||USD/JPY = 119.968|
Now a pip is the smallest increment in which a currency pair can move. It is usually the fourth decimal place of the quote currency in a pair. In the case of the Japanese yen (JPY), the pip is the second decimal place of the quote currency.
Let’s trace the pips in the above examples:
|EUR/USD||EUR/USD = 1.07339 (1/10,000th place)|
|GBP/NZD||GBP/NZD = 1.9502 (1/10,000th place)|
|USD/JPY||USD/JPY = 119.968 (1/100th place)|
So why are pips important?
Pips are important because they determine your profit or loss. Your profit or loss is calculated according to the number of pips that the price rises or falls.
- If GBP/NZD moves from 1.9502 to 1.9503, we have a rise in value of 0.0001, or, one pip.
- If GBP/NZD moves from 1.9502 to 1.9507, we have a rise in value of 0.0005, or, five pips.
- If EUR/USD moves from 1.07339 to 1.07359, we have a rise in value of 0.0002, or, two pips.
- If EUR/USD moves from 1.07339 to 1.07324, the price has decreased by 0.0015, or, 1.5 pips.
How about the fifth decimal place in EUR/USD, or the third decimal place in USD/JPY? That is a fractional pip called point. The reason it is shown is to give traders a more accurate indication of price movements.
Always remember that successful trading is based on a simple formula:
Make pips – keep pips – repeat
Pips should not be confused with ticks. While a pip is the smallest increment by which a currency can change in value, a tick is the increment by which it actually does. In other words, the actual moves that a price makes, irrespective of the number of pips that each move is worth, are called ticks.
Now that we’ve explained what pips are, it’s time we looked at how we can calculate their value.
First of all, pip value is determined by the size of a trade. The size, or volume of a trade is ordinarily calculated in lots. In forex, one lot represents 100,000 units of the base currency, so one lot of EUR/USD would equal 100,000 euros. Over the past few years, mini and micro lots have also been made available to traders:
|LOT||NUMBER OF UNITS FX||GOLD||SILVER||OIL|
|Standard||100,000||10 oz||500 oz||100 barrels|
|Mini||10,000||100 oz||5,000 oz||1000 barrels|
|Micro||1,000||1 oz||50 oz||10 barrels|
To determine the pip value for a particular currency pair when trading, you can apply the following:
Pip in decimal places X Trade size = Pip value in the quote currency
To better understand this, let’s assume that you are trading one lot of EUR/USD. The pip value would be calculated as follows:
|0.0001 (pip in decimal places)||X||100,000 (trade size = 1.0 lot)||=||$10 (the quote currency)|
Let’s calculate the pip value of a mini lot of EUR/USD:
|0.0001 (pip in decimal places)||X||10,000 (trade size = 0.1 lot)||=||$1 (the quote currency)|
And of five lots of EUR/USD:
|0.0001 (pip in decimal places)||X||500,000 (trade size = 5.0 lots)||=||$50 (the quote currency)|
To calculate pip value in the base currency of a currency pair, you can apply the following:
Pip in decimal places X Trade Size / Market price
What is a spread?
The spread is the difference between the Bid and the Ask prices of a currency pair.
Broker spreads are quoted in pips. A 1.5 pip spread means that there is a difference of 1.5 pips between the Bid and Ask prices on a specific currency pair.