Concept #3: ‘Pips’

What the heck is a ‘pip’? A pip, in Forex terms, is defined as the smallest price change an exchange rate can make. Most of the currency pairs you trade will be quoted out to four decimal places, and a shift in any of those decimals reflects a shift in price.

A ’standard’ pip is equivalent to 1 Basis Point or 1/100th of 1%.

Again, however, most currencies (with the exception of the Yen) are quoted to four places, which means that shifts can occur in the thousandth and ten-thousandths place.

Therefore, for most major currencies:

1 Basis Point = 1/10000th of 1% = 1 Pip

While the Japanese Yen, which is only quoted to the hundredths place, follow the traditional definition of:

1 Basis Point = 1/100th of 1% = 1 Pip

This is not cut and dry, though. The actual value of a pip can be fixed or variable, depending on:

1) The currency pair being traded
2) The base currency used in your trading account.
3) The lot size of your trade.

Now we have a new term to define before we proceed: What is ‘lot size’?

Lot Size refers to the size of your transaction or ‘contract’. Again, trading on Forex is all about volume. Almost no one trades unit for unit, or ‘dollar for dollar’, although some brokers do allow this.

The typical lot size for most trades, though, is in multiples of ten:

- A Standard Lot = 100,000 units of the base currency
- A ‘Mini’ Lot = 10,000 units of the base currency
- A ‘Micro’ Lot = 1,000 units of the base currency

Calculating Pip Values

This is one area where new investors can become very confused. This is because pip values are dependent on multiple variables.

The standard definition says that a pip is equal to a change of 1/100th in the value of a currency, but this change is not measured solely against the previous value of the currency!

Instead, one must take into account whether the currency pair in question has a fixed value or a variable value relative to the lot size. Further, one must take into account how many decimal places are quoted for the pair.

As you saw earlier, the EUR/USD pair is typically quoted to 4 decimal places, such that if the exchange rate were to shift from ‘1.4436′ to ‘1.4437′, you can say that is has gained a full basis point, or 1 pip.

Contrast this with the USD/JPY pair, which is only quoted to 2 decimal places. In this case, a move from 113.27 to 113.26 represents 1 pip at a value of .01.

Before you get too confused…

You should know that there is only one reliable source for quotes: Your Broker . The examples used in this series of articles so far are just that: examples.

I’ve shown you EUR/USD pairs with more than 4 decimals places in the quote - and I’ve shown you a USD/JPY pair with more than 2 decimals in the quote.

Do not let this confuse you.

The fact is that you can get quotes online from a variety of public sources, but these quotes do not reflect the true buy/sell rates.

Instead, they represent what is known as ‘mid-market rates’.

Mid-market rates are calculated by finding the average between buy and sell rates on high-volume transactions throughout the entire market. Further, every broker has its own set of fees or overhead charges per transaction, and these fees are included in the quotes they provide.

So, when you look at the mid-market rate, what you’re looking at is an average, not an exact quote. This is why the number of decimal points appears to vary.

Once you have your own account with a reputable broker, though, you’ll receive accurate quotes which follow the ‘rules’ regarding how many decimal points out a quote should go on a given currency pair.

A Typical Pip Value Calculation

The EUR/USD pair has a fixed value of U.S. $10 for Standard Lots, or 100,000 units of base currency. Similarly, a ‘Mini’ Lot transaction of EUR/USD has a fixed value of U.S. $1.

In order to calculate the actual pip value of the base currency within the pair, you must divide 1 pip by the current exchange rate, then multiply the result by lot size:

EUR/USD = 0.0001 (1 pip) / 1.30000 (exchange rate) =
EUR 0.0000769 x 100,000 (standard lot) = EUR 7.69

Next, we want to get our result into the base currency of our account. If your account uses U.S. Dollars for the base currency, you would multiply again by the exchange rate:

7.69 x 1.30000 = $10.00 pip value

What Do Pip Values Tell Me?

Pips are used by Forex traders to calculate profit and loss. Recall, again, that pips represent the smallest increment changes in price of one currency relative to another.

In our EUR/USD example, a change in value of 1 pip means a potential profit or loss of U.S. $10. Whether you earn $10 or lose $10 depends on the value of the Euro relative to the Dollar (or vice versus).

Right now, the Euro is stronger - so, any downward change in the Euro would actually create a profit for you in U.S. Dollars. You would profit from ‘buying high’ and ’selling low’, as counterintuitive as that sounds.

The reason Forex traders use pips to calculate profit and loss is because it simplifies the trade - or, I should say - because standard lot sizes simplify trades.

Pips calculations reflect the fact that almost all Forex transactions are undertaken in some multiple of 10.

We trade in lot sizes of 100,000, 10, 000 and 1,000 so that the effects of even the slightest change in currency values can be seen right away, and capitalized on immediately.

The good news that you don’t have to calculate these values yourself. Your broker will do it for you, and the information will be available in your online account.

It is crucial that you understand pips values on the conceptual level, even if you don’t want to do the math yourself.