You have probably heard of the terms pips, points, pipettes, lots, etc. in forex, right? These terms have an important role in forex trading and every trader is required to have a great understanding of them. Feeling comfortable with pip values and calculating profit and loss using them is a must-have achievement. We are going to explain what they are and how their values are calculated at the end.
When we trade forex, we are buying or selling a currency pair, such as EUR/USD, GBP/USD or USD/JPY, etc. The first currency in a pair is the base currency, while the second is known as the quote currency (sometimes also the counter currency). The price of a currency pair tells us how much of the quote we will need to buy a single unit of the base.
What a buy forex position means?
Let’s say that EUR/USD is trading at 1.2010. The euro is the base currency, and the US dollar is the quote. It means it costs us $1.2010 to buy a single euro. Forex traders always look to profit from the fluctuations in the exchange rates of currency pairs.
So, if we imagine that the euro is going to strengthen against the US dollar, we want to buy EUR/USD to make a profit on the move of the price up. Taking a buy position is often referred to as a long position.
EUR/USD buy example
EUR/USD is trading at 1.2010 and we buy €10,000 for $12,010. The EUR/USD pair moves up to 1.2110 as we sell our €10,000 for $12,110. This means we have earned a $100 profit. However, if EUR/USD had moved down to 1.1910, our position would have a $100 loss.
What a short forex position means?
Contrary to the opening of a buy, we can also sell the currency pair. If we think that the base currency is going to fall against the quote currency, we can sell the pair instead. A sell position is often referred to as a short position. So when we sell forex, we are buying the quote currency by selling the base currency.
In this case, this gives us a position to earn a profit when our chosen pair falls in value. This is also one of the reasons why trading forex is actually so popular. There are no restrictions or extra charges associated with going short, so we can easily trade into both directions.
GBP/USD short example
GBP/USD is trading at 1.3010 and we buy $13,010 USD by selling 10,000 GBP. Then, the GBP/USD falls to 1.2902 and we sell our $12,902 to get the original £10,000 back. This returns us $108 as profit. Contrary, if GBP/USD had risen instead, you would make a loss of $108.
WHAT IS A PIP?
Pip is an acronym for “percentage in point” or “price interest point”.
A pip is a measurement for every tiny movement of the forex pair. It is used to define the change in value between two currencies. A pip is the smallest standardized move that a currency quote can change by.
Traders use pips to calculate the spread between the bid and ask prices of the currency pair. Thus expressing the profit or loss that their position has made.
In most currency pairs, a value of one 1 pip is equivalent to a single-digit move in the fourth decimal point of a currency pair’s price. There is one exception to this rule in currency pairs when we have the Japanese yen (JPY) as the quote currency. In this case, a move of one pip is equivalent to a single-digit move in the second decimal point. This is due to the yen being worth comparatively little against other major currencies.
Let us take a look at the EUR/USD currency pair for example. If the market moves from 1.1800 to 1.1801, that 0.0001 increase in price would be a single pip move.
If you had entered a long position on EUR/USD, and the market moved from 1.1800 to 1.1850, this means we have gained 50 pips and profited from the increase. In the case the market moves against us, for example falling from 1.1800 to 1.1750, this decline of 50 pips would mean that your position made a loss.
In the case of the USD/JPY currency pair, let’s say it moves from 110.25 to 110.20, So this move down is worth 5 pips.
If we look at the USD/JPY currency pair, a move of 115.01 to 115.02 would be a single-pip move. We decide to enter a long position on the pair, and the price increased from 115.00 to 115.08. This means that the market has moved by 8 pips, and your position would be showing a profit. And indeed vice versa, if the price moved down by 8 pips (from 115.00 to 114.92), you would have a loss.
What are fractional pips or pipettes?
When you watch the currency forex pairs, you will also notice an extra fifth digit after the pip on a forex quote. Those are known as fractional pips or pipettes.
There are some brokers who quote their currency pairs with 5 or 3 decimal places, so one more than the standard 4 and 2 behind the dot. An example with EURUSD: standard usage would be 1.1234 while some would have 1.12345. That fifth digit is the pipette.
Sometimes, they are written in smaller font sizes (superscript) that we know are different from the pips.
How do we calculate the value of pip?
As we learned, one pip is worth 0.0001 (or 0.01% if you think of a percentage) of a single unit of the quote currency. This means we have to trade 10,000 units of the base currency to earn one unit of the quote for each pip of movement. An example: 0.0001 x 10,000 = 1 pip.
Formula: Pip value = (0.0001 x trade amount) / spot price
The amount of the base currency we trade is known as the lot size. We use four of them: Standard Lot, Mini Lot, Micro Lot, and Nano Lot Size.
So, to earn $1 for every pip that EUR/USD moves, we have to trade the equivalent of €10,000. See pip values for all currency pairs.
Keep in mind the exceptions like pairs with yen (JPY). One pip there is worth 0.01 (or 1%) of the base currency when the quote is the yen. So, when we trade $10,000 of USD/JPY, we gain or lose ¥100 for each pip that USD/JPY moves, up or down.
If USD/JPY is trading at 110.00, then that is the equivalent of $0.91 (coming from: 1 pip/110.00 x $10,000 = $0.91).
Here is an example of USD/JPY trade
We decide to buy $10,000 against the Japanese yen at 106.20 and we gain a profit of $0.94 for every pip increase in our trade direction. If we sold the position at 106.40 (a 20-pip increase), this would make us a profit of $18.80. On the opposite, if the price moved down against us to 106.00 (a 20-pip decrease), then we have a loss worth $18.80.
As we see, one pip is really a small value in real terms. That is why forex traders use leverage to take advantage of the constant fluctuations in prices. Leverage means that we are only required to put up a small amount of money (known as margin) to control a much larger amount. This gives the retail traders a chance to open short-term forex positions without investing thousands of US dollars worth of capital.
We will cover more details about leverage and the risk it brings to our trading in the other topic. We have to properly understand how leverage works and how it can harm our trading account if its understanding is not good enough. This is where many traders have issues and over risking their capital.
Leverage significantly magnifies both your profits and your losses, so it requires very careful risk management.