If you are a FOREX trader, it is likely you will hear the term pip every day of your trading life. As you become more experienced, you will learn how to apply this term and you will get better at making pip calculations like they are second nature. This brief article intends to strip the term and its application down to the basics so you can understand what a pip is and how to use it.
What is a Pip?
A pip is the short version of the term “percentage in point.” It is a term used in FOREX trading. Let us remember what the FOREX world is about – people and organizations trade global currencies that are matched in pairs to make it easier to tell how strong or weak one currency is in relation to the other. In the FOREX world, a pip is a measure of how much the value between two currencies changes.
The relative value between currency pairs is shown in number form with four decimal places. A pip represents the last of those four decimals and is, therefore, a small unit of change. Why bother with such small values? Well, the FOREX world is highly leveraged and high volumes of FOREX change hands. So, pips, as small as they are, matter.
Here is an example. At today’s exchange rate, one euro will buy you 1.0532 US dollars. If you were trading the euro against the US dollar, one pip would be the smallest movement that could take place between the two currencies. If the EUR/USD (you always quote the base currency first) moved from 1.0532 to 1.0533, or even 1.0534, that 0.0001 change in value is one pip.
Pips and Profitability
How do pips work when it comes to actually making money from trading? An investor who trades the EUR/USD will make a profit if the Euro appreciates in value relative to the US Dollar. Here are the steps involved. Let us say you are a FOREX day trader. On Monday morning, you use EUR10,000 from your euro-denominated FOREX account to buy USD10,053.90 at a EUR/USD rate of 1.0539. Now you hold this USD amount in your account and wait for the market to swing your way.
At lunchtime on Monday, a major announcement in the US reveals that economic prospects are poor. The US dollar weakens based on pessimistic sentiment from market players. Now, the EUR/USD rate shifts to 1.0531, a change of 0.0008, or eight pips. Sensing an opportunity, you quickly convert the US 10,053.90 back to euros, at a rate of EUR/USD 1.0531. By the end of the day, you now have EUR10,007.60, more than you started with in the morning. You have thus made a profit of EUR7.60.
This very simplistic example doesnot consider fees and commissions, and does not account for leverage, which is a way of opening much larger positions than the capital in your account. With some brokers, you can leverage your trades as much as 200 times over, using 1:200 leverage. The example here is meant to illustrate the function of a pip at its most basic level.
You might think that this is a small profit for one trade, but the example does not show that day traders can easily enter and exit hundreds of trades per day with lightning-fast execution, and even use algorithmic trading bots that place trades on your behalf. Additionally, when you trade on margin, you are entering these large positions with some of the broker’s money and some of your own, so you don’t need as much capital.
Further, the amount of volatility between major currencies like the EUR and USD is very small compared to the amount of volatility (and number of pip differences) you can find between a major currency and an emerging currency. This means you could make even more money if you successfully traded major currencies against minor currencies. There is a world of possibility regarding how you can make money in FOREX, and the humble pip is at the very center of it all.
The Bottom Line
As a trader, you will need to become accustomed to this very important term. Pips are the smallest unit of change in value between two currencies. Learning how to use this term so that it becomes second nature will serve you very well over the course of your trading career. Even if you change FOREX brokers, the rules of pips do not change, meaning you can easily read charts and indicators from any broker with whom you choose to work.
Adrian Ashley is a seasoned business and finance writer. With a corporate career spanning over 20 years, he has developed deep experience in such diverse areas as investing, business, finance, technology and macroeconomics.