What is a Pip and What Does it Represent?

What is a Pip
and What Does
it Represent?

A commonly used term in forex trading, a pip refers to the smallest variation in the price of a currency pair and is expressed in decimal points. Measured in terms of the quote or underlying currency, a pip is known as the 'Percentage in Point' or 'Price Interest Point'. This standardised unit for measuring change in the price of a currency pair is usually set at $0.0001 for those pairs that have the US dollar as one of the constituents.

It is also referred to as 1/100th of 1%, or 0.01%, or one basis point. The basis point is the common unit of measurement for interest rates and their financial percentages. The reason for having a standardised size is to help protect investors from massive losses. The larger the pip movement, the higher the volatility in the price of currencies.

Although initially used to measure the change in the prices of currencies, a pip is widely used to represent the change in the prices of other financial instruments too. One example of this is contracts for difference (CFDs). For traders interested in trading currencies or CFDs, a clear understanding of the term pip is essential to analyse the movements in markets and estimating the potential profits or losses generated by a trade.

If the exchange rate for a currency pair is expressed to two decimal places, as in the case of the yen, the pip is equal to a change of 0.01. Where the currency quote is expressed to four decimal places (most other major currencies), a pip is equal to a change of 0.0001.

What are Pips in
terms of Currency
Pairs and Price

Before we try to understand pip through an example, we need to know that:

  • Most currency pairs are quoted to the fourth decimal place, wherein the pip is the last and smallest of the numbers. This four decimal point method used for quoting foreign exchange prices means that for a standard lot of currency, sold in batches of 100,000 units, a price change of 1 pip is equivalent to 10 units of a currency. If it is a mini lot of 10,000 units, the price move of 1 pip equals 1 unit of the currency.

  • Although pip is a very small unit of measurement, it can result in significant profits or losses for forex traders, especially when high levels of leverage are used.

  • A price quote consists of two parts. One is the big figure or the handle, while the last two digits refer to the dealing price, which moves in pips. If the quote price is 1.0345, the first portion, that is 1.03, is the handle price, while the last two digits, that is 45, refer to the dealing price in pips. The handle changes only when there is a significant change in currency prices, while the dealing price in pips may change several times in intraday trade due to a variety of factors.

  • Currencies are always traded in pairs, with the first one known as the base currency and the second one as the counter currency or quote currency. The quote price means that the counter currency is being expressed in its value per unit of the base currency. For instance, if the quote for GBP/USD is 1.3421, it means that each unit of the US dollar can be traded for 1.3421 units of the British pound.

  • Now, depending on the exchange rate, each pip can have a specific value, in terms of the counter currency. In simple terms, we need to divide one pip by the exchange rate and then multiply it by the lot size.

What Factors
Determine Pip Value?

The value of a pip in monetary terms is dependent on three factors:

1. The currency pair being traded

2. The size of the trade, and

3. The exchange rate.

Let’s look at an example of calculating the pip. Say, we have a GBP/USD direct quote of 1.3210. This means that you will require 1.3210 US dollars to buy one British pound. Now, if there is a one pip increase, which takes the quote to 1.3211, it means that you will now need 1.3211 USD to buy one GBP.

Another thing that forex traders need to be aware of is that the total impact of a one-pip change on a transaction will also depend on the number of units being purchased. When a trader buys 10,000 pounds by paying in US dollars, they will have to pay 10,000 x 1.3210 or $13,210.

Now, if the exchange rate of this pair rises by one pip, the price to be paid for buying 10,000 GBP will be 10,000 x 1.3211 or $13,211. This means the pip value when the lot is 10,000 pounds is 13,211 – 13,210 = 1 US dollar.

How to Calculate the
Value of a Pip?

The value of a pip depends on the lot size being traded, the execution price and the pip move. For instance, if the pair being traded is the EUR/USD and the lot size is the standard 100,000 units. The pip value can be estimated by multiplying 100,000 by the minimum pip value that the EUR/USD moves by or 0.0001. This will give a pip value of $10.

On the other hand, if we take the USD/JPY pair, where the minimum pip increment is 0.01, a lot size of 100,000 would mean a pip value of 100,000 x 0.01 = ¥1,000. Note that the pip value is calculated in terms of the counter currency, or the second currency in the pair.

Are Pip Values
the Same for Every
Currency Pair?

No. The pip values differ for each currency pair as the value depends on how the currency is traded. While most currency pairs use 0.0001 as one pip, Japanese yen-based pairs, such as the EUR/JPY , GBP/JPY and USD/JPY, use 0.01 or 1/100th of the exchange rate as one pip, due to the low value of the yen.

What is a
Fractional Pip?

While most currency quotes are displayed to four decimal places, in some instances, where very large transactions take place, quotes may be made in up to five or even six decimal places. Also, advancements in electronic trading made available by forex brokers have allowed investors to trade in fractional pips, called pipettes or nano pips. These permit pricing to a tenth of a single pip. This allows persons trading forex to work with very small price increments.

The fractional pip or the nano pip represents the price change of the fifth or sixth number after the decimal point for most currencies and the third number in case of currency pairs involving the Japanese yen. The value of a fractional pip is one-tenth of a pip and is standard for most trading platforms.

Forex traders need to be aware of the daily average price ranges and the level of pip for various currency pairs as this allows them to measure the volatility in the forex markets. If the average price range of the forex pair being traded does not meet the estimated ranges, traders might need to revise their target range.

What is a Pip Value

Calculating the pip value for currency pairs that do not include the US dollar can be difficult. The process can be made easier with the use of an online pip value calculator which simply requires the user to input their account’s base currency. The calculator then estimates the value of a pip by multiplying the size of the lot by one pip, in decimal terms, and then dividing the result by the current exchange rate of the quote currency.

The calculator provides the value of a pip for the standard unit size of 100,000, mini lots of 10,000 units and micro lots of 1,000 units. The calculator is quite useful and allows traders to estimate potential profits or losses. Most forex brokers provide a pip calculator.

How Does
Leverage Impact the
Value of a Pip?

The amount of leverage being used by a trader impacts the total pip value. When a trader uses higher leverage, they gain greater exposure to the market. This means that even a small change in the pip value could have a massive impact on their trading account. The amount of leverage offered by a broker can be as low as 1:2 or as high as 1:500, depending on the size of the brokerage house, the instruments being traded and the trader’s risk profile.

It is important to understand the pros and cons of leverage. For instance, if a broker offers leverage of 1:50 and the standard lot for trading is $100,000 of the quote or counter currency, the trader will need to deposit 1/50th of $100,000, or $2,000, to enter a position. The remaining amount is loaned by the broker, as leverage.

In forex trading, price changes are measured in pips and for every pip movement, a standard lot registers a change of 10 units. Now, if the trader has $20,000 available for trading and chooses leverage of 1:50, they can enter into positions worth up to $1,000,000 in CFD trades. This amount equals 10 standard lots in forex trade, since each pip movement costs $100.

In circumstances where the underlying instrument’s price rises by 20 pips and the trader holds a long position, they could gain $100 x 20 or $2,000. If, however, the market moves in the opposite direction, the trader could lose the same amount, or $2,000.

High leverage levels can result in significant gains as well as losses. Therefore, adequate risk management strategies are vital. Most reputable forex brokers offer demo accounts for new traders to develop an understanding of forex trading and provide them with the opportunity to develop a trading plan without exposing their own capital.

Why is Pip

A pip is used to calculate the spread between the ask and bid prices of a currency pair and to calculate the potential profit or loss that might result from a position. A clear understanding of pips helps traders manage their trades and formulate trading strategies.

Cost of Trading

Pip is very important for determining the cost of trading. In currency trading, brokers offer to sell a currency at one price and buy it back at a lower price. So, a broker expresses a currency pair in terms of the ask or buy price and the bid or sell price. For example, if the ask price for the GBP/USD is 1.3421, it means that 1.3421 USD will be required to buy 1 GBP. If the bid price is 1.3417, it means that 1 unit of GBP can be sold back to the broker for 1.3417 USD.

The quote price (bid/ask) for this currency pair is 1.3417/1.3421. Note that the ask price is always higher than the bid price, to ensure that the broker is able to cover their cost of doing business. This difference between the bid and the ask price is called the spread, which is 4 pips in this case.

Spreads are influenced by several factors, such as the volatility in the market, the level of uncertainty and the liquidity. Important announcements by the central banks or economic data releases are the most common reasons for the widening of spreads. Apart from scheduled events, factors such as political turmoil or other unscheduled events can also widen the spread.

Spreads can be wider if the market is highly volatile or the volume being traded is extremely low. In short, the spread, which is expressed in terms of pips, is the minimum amount that the broker will earn on the purchase or sale of a currency or the minimum amount a trader will pay on buying or selling a currency, if there is no change in price. While looking to open an account, traders should look to open accounts with brokers offering tight spreads. Some brokers offer spreads as low as 0.0 pips because of their high liquidity levels.

Potential Profits and Losses

Tracking changes in pip value is very important for traders, since it helps them determine the potential profit or loss of a trade. Traders earn profits or incur losses as exchange rates vary throughout the trading session. If the bid/ask spread in the above case moves from 1.3417/1.3421 to 1.3427/1.3431, which means the trader can now buy at 1.3431 and sell at 1.3427, he would earn a profit of 6 pips. However, if the bid/ask quote changes from 1.3417/1.3421 to 1.3419/1.3423, the trader will buy the currency at 1.3421 and sell it at 1.3419, which means they will incur a loss of two pips.

Although the exchange rate has risen, it has not moved enough to compensate for the cost of the spread of four pips. The total cost for the trader in this case comes to 6 pips, which includes the spread of 4 pips and loss of 2 pips. This emphasises the importance of liquidity and costs associate with trading.

When a trader wishes to calculate the actual amount gained or lost, they can multiply the number of pips changed at the close of the trade by the base currency (dollar, in this case) value of each pip. In the above example, if the currency value or the USD value in pips is $10 and the currency quote changes by 10 pips from 1.3421 to 1.3431, the trader would earn a profit of $10 x 10 pips in price change, which is equivalent to $100.

Managing Risks

Pips help traders manage risks and calculate the appropriate level of leverage to use for trades. Traders can use stop loss orders to limit the amount they lose, if the trade moves in a direction opposite to their prediction. Pips can also help traders calculate the best position size to take, without being exposed to excessive risks.

How Relevant are Pips
for CFD Trading?

So far, we have talked about pips measuring the change in prices of currency pairs. However, they can also measure the change in the prices of other assets, such as Contracts for Difference or CFDs. While CFD trading does not involve buying or selling the actual assets, it refers to trading contracts associated with the price movements of the underlying asset. A CFD trade involves a trader entering into a contract with a broker regarding the future price movement of a currency pair, index, commodity or any other financial instrument.

There is no actual purchase or sale of the underlying instrument in CFD trading and the size of the payout is decided by the direction of price movement and the pips. CFD trading, like forex trading, uses pips that represent the smallest change in the price of the underlying asset, which also influences the price of a CFD. So, in CFD trading, the pip represents the minimum amount by which the underlying asset or financial instrument needs to change in value before the CFD changes its value.

The value of a pip is dependent on the currency pair being traded, the exchange rate and the total size of your trade. The calculation of the pip value helps traders understand how much profit or loss they are likely to experience with a specific trade position. The MT4 trading platform, offered by reputed brokers, comes with several inbuilt tools that aid in the quick calculation of a pip and development of a risk management strategy.

What is the
Difference Between
the Pip Value for
Different Currency

The currency used by a trader to open a trading account determines the pip value. If a trader opens a US dollar denominated account, then the pip value for currency pairs, with the USD as the quote or counter currency, is $10 for a standard lot, $1 for a mini lot, $0.10 for a micro lot and $0.01 for a nano lot. These pip values change when the value of the USD changes by a significant percentage of more than 10%. Many forex brokers allow persons living outside the United States to open a US dollar denominated account.

However, if the account is funded in USD, but the US dollar is the base currency, the value of the pip is determined by dividing the normal pip value by the exchange rate between the USD and the counter currency.

If the trading account is funded by a currency that is not the USD, the pip value remains the same, regardless of whether the funding currency is the quote or counter currency. So, for a euro or British pound denominated account, the pip value will be €10 or £10 for a standard lot, €1 or £1 for a mini lot and €0.10 or £0.10 for a micro lot. However, if the currency used to fund the trading account is not the quote currency, the pip value is obtained by dividing the fixed pip rate by the exchange rate.

Again, if the pair being traded includes the Japanese yen (JPY), say the CAD/JPY, the result obtained by dividing the fixed pip rate by the exchange rate will need to be multiplied by 100. This is to account for the difference in the pips position, which is the second place after the decimal, in the case of the yen (instead of the fourth, in the case of other currencies).

To conclude, a clear understanding of pips and their effect on trade positions, profits and losses is important to make informed trading decisions.

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Source - database | Page ID - 970

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