Understanding Forex Trading Pips

If you are serious about becoming a successful Forex trader then there is lots of information you should try and learn about the strategies and theories involved with trading foreign currencies. However, getting started with Forex trading is relatively straightforward and many of the basic concepts are reasonably simple to learn.

Before you even think about jumping in and investing your money, you should make sure that you understand these basic concepts and, particularly, you should familiarise yourself with the terminology that is used in Forex trading. One specific term that you will encounter, and need to understand, is a “pip”. This article explains explains the use of the word pip in Forex trading and what a pip is.

What is a Pip in Forex Trading?

Pip is actually an acronym; it stands for Percentage In Point. Quite simply, a pip is the unit of measurement that is used to express a change in values between two currencies – it is the smallest price change that a specific exchange rate can make. As most major currencies are traded to 4 decimal places, a pip is the change in the last decimal point – the fourth one – and is therefore equivalent to one hundredth of one per cent.

When you are Forex trading, you are always trading in pairs of currencies – that is you are effectively buying one currency and selling another. For example, you might be trading United States Dollars (USD) against the Swiss Franc (CHF). If the exchange rate between USD and CHF is at 1.1956 and then moves to 1.1959, it has moved 3 pips.

Calculating the Value of a Pip

As each currency has a value which is expressed by its relationship to another currency, a pip can have different actual values depending on which currency pair is being traded. The simplest way to determine the value of a pip is by dividing 0.0001 by the exchange rate of the relevant currency pair. A couple of examples are listed below.

Assume the USD/EUR rate is 0.7341. You would divide 0.0001 by 0.7341, which equals 0.000136. The value of a pip for the USD/EUR currency is therefore .000136.

Now assume the USD/EUR rate is 1.0146. You would divide 0.0001 by 1.0146, which equals .000099. In this case, the value of a pip for the USD/EUR currency is .000099.

The exception to the above is for currency pairs involving the Japanese Yen (JPY). Exchange rates involving the JPY are only quoted to 2 decimal places. Therefore, to calculate the pip of a currency pair that includes the JPY, you would divide .01 by the exchange rate.

Pips, Lots and Leverage

There are two things that stand out from the above examples. Firstly, that there can be a lot of calculations involved in working out the relevant pips, particularly if you are trading multiple currency pairs on a daily basis. However, while it is important that you understand how a pip is calculated, you don’t really need to worry about calculating the pip value yourself as most online trading platforms will do that calculation for you. Secondly, you are likely to be wondering how you can make money out of Forex trading when the value of a pip is so low – and this is where lots and leverage become relevant.

When you are trading Forex, you will usually trade in “lots”. The standard size of a lot in Forex trading is $100,000 ($10,000 is referred to as a mini lot) and when you are trading with that kind of money, a few pips movement can make a substantial profit - or loss, of course. You don’t necessarily need to have that kind of money spare to be able to make sizable Forex trades, as it is possible to use leverage to make your money work harder for you. If you are not familiar with leverage, this is where you use borrowed funds based on the actual amount of money you are able to invest. It is possible to get leverage at ratios of 100:1 or even higher.

Bid/Ask Spread

There is a fundamental difference between trading Forex online and trading stocks when it comes to the transaction costs. When you are trading stocks, or other financial instruments, you will be charged a commission by your broker every time you buy or sell. However, when you are trading Forex, there is no such commission to pay – the cost of the transaction is the difference in pips between the bid price and the ask price of the currency pair you are trading. At any point, the cost of buying a currency will be marginally higher than the sale price you can achieve. Therefore, when you are buying, you will need the currency to increase a certain amount of pips just to break even.

Generally speaking, the more active trading is on a particular pair of currencies, the lower the spread will be. Typically, an actively trading pair such as USD/EUR will have a spread of just 2 or 3 pips. Understanding pips, lots, leverage and the bid/ask spread is crucial to making a profit in Forex trading, so you really should take the time to make sure you fully comprehend all the information above.