What is a Pip in Forex
20 Mar 2019
Perhaps, you were watching a movie trailer on YouTube and just from nowhere, this ad pops up with a guy telling you how you can make money in Forex. The ad gets your attention, and you decide to listen to what this guy has to say. Then, as it was getting interesting, the guy started speaking of making 100 pips a day. The ad that was already interesting turns out to be confusing.
You were left wondering, what exactly is a pip? And why was he quantifying his gains in pips? No worries, this article will smooth out your knowledge about pips.
So, what is a pip in forex?
A pip is the short name for Percentage in point, and it represents the smallest change in the value of a currency pair. For most currencies, especially the majors, a pip is represented by the fourth decimal point of the two currencies’ exchange rate. However, this is not always the case, for some currency pairs. For the ones paired with JPY, a pip is represented by the second decimal point.
Let us use an example, suppose you are a trader trading the EURUSD. So, you opened a buy position when the exchange rate was 1.2712. You predicted that the rate would go up, after a few minutes, the price moves to 1.2713 and you decided to close your trade. The price change here is 0.0001, which is equivalent to 1 pip.
Let’s look at a real market situation. Assume that you opened a buy position when the price was 1.1438 as shown in the chart below. You predicted the price would go up, but the price goes the opposite direction. You then decide to close the position when the exchange rate was 1.1431. How much have you lost? You will have lost the total change in the value of the pair, which is, 0.0007 that is equivalent to 7 pips.
What is a Pipette?
Majority of the trading platforms will use pips as the smallest units to measure the change in the value of a currency pair. However, the need for more accuracy has led to the introduction of a pipette; which is a 1/10 of a pip. So, in this case, a pipette is represented by the fifth decimal point on your trading platform, and the third decimal point for currencies paired with JPY.
Let us make use of the previous example, but this time with a broker platform that allows for the use of Pipettes.
In this example, you opened a buy position when the exchange rate was 1.14387. You were anticipating the prices would go up; unfortunately, that was not the case. Instead, the price went against your position. You decide to close your trade at 1.14312; you end up losing 0.00075 which is equivalent to 75 pipettes.
I know after looking at this example you are able to appreciate the level of precision that comes with Pipettes. Pipettes give a trader a higher level of accuracy than the pips. In the previous example, the loss was 7 pips but using pipettes, we get a clearer picture its 75 pipettes (7.5 pips)
The Importance of Pips in Forex Trading
You will make use of pips to quantify how much you have gained or lost in a certain trade. Expressing your gains or losses in amounts can be confusing and hard to compare. This is because the amount of dollars gained or lost relies on very many factors.
A small move in the market could lead to huge gains money wise, while on the other hand, a huge market movement could lead to just a small gain in terms of dollars. This leaves pips as the only sure way of quantifying the market movements.
Value of pips
A pip value can be defined as the price that is attributed to a movement of one pip in the forex market. If you are in a buy position and the price is ticking in your favor, your open trade will rise in value; similarly, when the price goes against you, the open position decreases in value. A pip value will tell you how much the incremental gain is worth. To get that value, we need to calculate the pip value.
Since the value of a pip is very tiny, forex is always traded in standard lots, mini lots and micro lots. A standard lot has 100,000 units of the base currency; a mini lot has 10,000 units while a micro lot has 1000 units of the base currency. We also have a Nano lot that has 100 units of the base currency. Here is how different lot sizes affect the value of a pip.
|Lot size||Base currency units||Volume||Pip Value in USD|
|1 standard lot||100,000||1.0||1 pip=$10|
|1 mini lot||10,000||0.1||1 pip=$1|
|1 micro lot||1,000||0.01||1 pip=$0.1|
|1 Nano lot||100||0.001||1 pip=$0.01|
Calculating pip value and position size with examples
As we detailed earlier, pip value tells you how much a one pip movement contributes to your profits or losses. Pip value is significant as it helps you in risk management. If for example, you don’t understand pip value, then how can you calculate the ideal position size? So if you do not get this concept, it will be hard for you as a trader to measure and manage your risk.
|Pip value||=||(1 pip/Exchange rate of the pair)*Lot size (in base currency, i.e the currency listed first)|
Assume that you want to calculate the pip value of a Euro-denominated account, for EUR/USD where the exchange rate is 1.2 for 1 lot. Here 1 pip is same as 0.0001.
Pip value= 0.0001/1.2*100,000=8.333 Euros
Pip value for USD-denominated Accounts
The dominant currency in many trading accounts is the US dollar. Whenever the USD is placed second in a pair where the account is denominated in dollars, then the pip value doesn’t change.
In such a case, the pip value for a standard lot will be $10; a mini lot will have a pip value of $1 while a micro lot will have a pip value of $0.1. This applies to any pair as long as the USD is listed second. Here are a few examples: EUR/USD, AUD/USD, GBP/USD, NZD/USD.
Where the USD is the base currency (listed first in the pair) simply use the formula above. Suppose you are trading a standard lot for the USD/CAD. As you can see, the USD, in this case, is listed first. So, assuming that the exchange rate for USD/CAD is 1.25, the pip value in dollars will be 10/1.25=$8. Here is how you can calculate the pip value for mini and micro lots as well.
Pip value for Standard lot= 10/ (USD/XXX)
Pip value for Mini lot= 1/ (USD/XXX)
Pip value for Micro lot= 0.1/ (USD/XXX)
Pip Value for non-USD-Denominated accounts
Let us assume you have a Canadian dollar account. Any time you trade a pair where the Canadian dollar is listed second, the pip value in such a situation remains fixed. In this case, the pip value for a standard lot will be CAD$10; a mini lot will have a pip value of CAD$1 while a micro lot will have a pip value of CAD$0.1.
What if the Canadian dollar is listed first like in the case of CAD/CHF? You will obtain the pip value by dividing the fixed rates above by the exchange rate. Assume that the rate of CAD/CHF is 0.8, so what is the value of a micro lot? It will be CAD$0.1/0.8= CAD$0.125. You can do the same for standard and mini lots.
Pip value for 1 lot= 10/ (CAD/XXX)
Pip value for Mini lot= 1/ (CAD/XXX)
Pip value for Micro lot= 0.1/ (CAD/XXX)
What if now the pair has the CAD as the base currency and JPY as the quote (CAD/JPY)? Let us use an example: So, assume the value of CAD/JPY is 90, what is pip value for a standard lot in this case?
We shall use the formula discussed above but then multiply by 100.
Pip value for 1 lot of CAD/JPY= 10/ (CAD/XXX)*100
You can use this process for other denominations e.g. EURO or even the Australian dollar.
The Pip value for the other pairs
You may be having a USD-account, but you are trading a pair that does not contain USD. For example, you have a USD account, but you decide to trade EUR/CHF or EUR/GBP.
Let us take the example of EUR/CHF. The rule was that if you have a CHF account and we are trading EUR/CHF, the pip value remains fixed; (CHF 10, for standard lot, CHF 1 for Mini lot and CHF 0.1 for a micro account)
Let us in this case assume we are calculating the pip value of a standard lot which is fixed at CHF10. So, if my account is USD-account, I will get my pip value by dividing CHF10/ (USD/CHF). That is the fixed value divided by the USD/CHF rate. If say the USD/CHF rate is 0.8, then the pip value will be 10/0.8= USD 12.5.
What then would happen if you did not find the USD/CHF rate, and instead you found the backward quote, that is CHF/USD? How would you go about that?
You simply get the inverse of CHF/USD. Assuming that you found CHF/USD rate to be 1.25, then the inverse would be 1/1.25=0.8.
Changes in the pip value
The base currency of your account in most cases will determine the pip value of the different pairs. If your account is USD denominated, and the currency pair has USD as the quote currency (listed second in the pair) e.g. EUR/USD, then the pip values remain remain fixed as we discussed earlier. In this case, the pip value for a lot will be $10; a mini lot will have a pip value of $1, while a micro lot will have a pip value of $ 0.1.
A change in pip value will only happen when the USD changes significantly by more than 10%, and in this case, the USD is the base currency (e.g. USD/CAD or USD/JPY) or the USD is not quoted in the pair (e.g. GBP/JPY); provided the account is a USD account.
A good example is when the exchange rate of USD/JPY fell from about 120 to a low of about 77 between 2008 and 2011. The rapid strengthening of the Yen caused the pip value of the pair to change. In this case moves in the market became more valuable as the pip value rose.
Using the knowledge obtained, let us see the effect the change had on the pip value of the pair. So the exchange rate, in this case, moved from 120 to 77. Before 2008, the pip value per a standard lot of USD/JPY in a USD denominated account was $10/120*100=8.333. Towards 2011, the exchange rate moved to 77, the value of the pip during that period rose to $10/77*100=12.98; making the market moves more valuable.
The relevance of Pip Values When Hedging
Hedging entails the simultaneous buying and selling of securities in a bid to reduce the risk involved. Many traders see it as a risk-free position as losses on one side are covered by gains on the other side. However, this may not always be the case. Hedging carries some form of risk since wide spreads can eat into both positions leading to losses.
The widening of spreads happens mostly during key global events like the moment the Swiss National Bank abandoned the cap on CHF against EUR in 2015. Brexit is another major global event that can severely hurt your hedged trades.
During such periods, the difference between the bid and the ask price can even be 100 pips, if that happens to your two positions; the results are likely to be devastating. Where the pairs involved are illiquid, the spreads are likely to be even wider leading to more losses to the hedged positions.
What is a pip for CFDs?
Before we get to the point of discussing pips in CFD, first things first: what is a CFD? A CFD is a contract that allows a trader to trade and take advantage of price movements of an underlying security without necessarily owning it.
So, do we have pips in CFD trading? The term is not commonly used in CFD trading; instead, there are terms such as cents and pence that are used in place.
If for example, the price of a CFD is $1.00, if the price moves up to $1.01, it will have moved up by one cent. Price in Cents is always to the right of the decimal; while to the left is the price in USD.
To this end, you have been able to understand that a pip is the smallest change that can happen in a currency pair. You have also been able to appreciate the vital role that pip value plays in our trading. In actual trading, you may not have to keep calculating the pip value as there are some online calculators to help you with that. To get more on this, register a demo account, and you will appreciate the impact the pip movements have of your profits.