What Is A Pip?

what is a pipSpeculating on the change in the comparative value of one currency versus another in a currency pair is the basis of the foreign exchange currency market (FOREX).

The smallest unit by which the value between two currencies can change is called a pip, and understanding the effect of this term on the profit or loss of a currency transaction is fundamental to trading Forex.

Which currency pairs are offered depends on the broker, but they all will typically offer the major pairs, and we will use the most commonly traded major pair, the euro/U.S. dollar (EUR/USD) for illustration purposes.

The debt crisis in the Eurozone that imposed itself prominently on the awareness of Forex traders recently has caused the value of the euro to decline versus the dollar. During early 2012 trading, quotes for the EUR/USD have been touching lows in the area of 1.27789. This means that a trader who wished to purchase euros with dollars would pay 1.27789 dollars for every euro.

New traders will wonder why there are five decimal places present in this price quote when U.S. currency has only two. The reason is that currency traders often engage in transactions of anywhere from thousands to millions of currency units, meaning that a small change in value in the exchange rate between the euro and dollar is magnified to an extent where the extra decimal places in the price quote have a significant effect on the outcome of a trade.

In this quote of 1.27789, the number 8 in the fourth decimal place represents a pip. The 9 is a micro pip. Ten micro pips equal one pip. Many traders will ignore micro pips entirely, since they mean very little to any trades other than very large ones, so to minimize confusion, permit us to change the quote to 1.27780.

If the euro should gain value against the dollar by the minimum amount of one pip, the quote would become 1.27790. A loss of one pip would become 1.27770.

From here, a brief look at the math of a typical trade will make the presence of the extra decimal places in the quote apparent.

If our trader in this first example where the exchange rate changed from 1.27780 to 1.27790 had purchased a micro lot (1000 units) of the EUR/USD, that trader would show a profit of 10 cents.

If that trader was trading a mini lot (10,000 units) the profit would jump ten times to $1.

With a standard lot (100,000 units) the effect on the trader’s account will be $10.

The exchange rate between the EUR/USD, even during placid trading periods, can easily change by 20 pips in a matter of several minutes. In this scenario, the micro trade will make a 20 cent profit, the mini $2.00 and the standard $20.

Factor in periods of high volatility, where the exchange rate can often change by 50 pips in a couple of minutes or less, and the necessity of four and five decimal place price quotes becomes obvious.

Understanding how a change of even one pip in currency prices will affect your trading account is critical to determining initial trade size. It should be small enough that if you are wrong in your price forecast and experience a drawdown, you still have room to maneuver, or exit the trade with no regrets. For more information on making this trade size determination, visit New Zealand’s preeminent Forex information provider,  Lucror FX,  today.

 

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