Trading Course for Beginners: Course 2

Trading Course for Beginners: Course 2
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Lesson 1 What is a Pip in the Forex Market?

Lesson 1 What is a Pip in the Forex Market?

Reading Time: 10 Minutes

The terminology used in financial markets is confusing for beginners. It’s akin to learning the foundations of a new language; consequently, the absence of proficiency in basic terms makes operating in any tradeable market (country) problematic.

Specifically, in the foreign exchange market—more commonly referred to as the Forex market—a ‘pip’ is an important term that Forex traders must have a firm grasp on to navigate FX charts confidently. A pip, an acronym for percentage in point or price interest point, represents a unit of measurement: a currency pair’s unit of change, equal to 1/100th of 1 per cent. Put simply, think of it as one unit of a per cent that denotes the smallest price movement of an exchange rate.

Currency
Pairs

The Forex market operates through currency pairs that deliver rates of exchange. An exchange rate presents the value of one country’s currency in terms of another country’s currency, hence its name: currency pair or Forex pair.

In each currency pair, irrespective of the currencies involved, a base currency and a term currency establish their framework. The base currency is stationed on the left-hand side of the quotation (the first currency) and signifies a whole number (one unit) of the base currency. The term currency accommodates the right-hand side of the quotation (the second currency) and is also referred to as either a counter currency, a secondary currency, or a quote currency. A currency pair’s structure remains the same irrespective of whether major currency pairs are traded or less liquid (and often more volatile) exotic currency pairs are explored.

Decimal Places

Although dependent on the Forex broker, with the exception of JPY pairs (Japanese yen) priced to three decimal points (0.010), the majority of currency pairs are priced to five decimal places (0.00010). The fifth (third) value is what’s known as a point—sometimes called a fractional pip or pipette (a tenth of a single pip).

Trading platforms, such as MetaTrader 4 (MT4), deliver bid and ask quotes through its Market Watch window, as shown in figure 1.A. The bid (ask) represents the value in which traders can sell (buy) the base currency.

(Figure 1.A: MetaTrader 4 [MT4] Market Watch Window)

To help solidify the concept of a pip, the GBP/USD (British pound against the U.S. dollar) currency pair, according to figure 1.A, has a bid of $1.25715. If the currency pair trades to $1.25745, this is a three pip move higher. Yet, should the pair trade from $1.25715 to $1.25718, this is a three-point advance.

Pip Value Calculation

Although Forex traders often depend on Forex calculators, an important skill market participants should become accustomed to is pip value calculation. How this is calculated rests on the currency the trading account is denominated in and the currency pair of interest.

• Account currency denominated in the same currency as the currency pair’s term currency:

Pip values, in this case, range from 0.10 units (micro lot), 1.00 units (mini lot) and 10.00 units (standard lot). For currency pairs including the Japanese yen (JPY), however, 10.00 units (micro lot), 100.00 units (mini lot), and 1,000 units (standard lot) are used.

Imagine a U.S. based investor who wants to purchase 10,000 euros and the EUR/USD (euro against the U.S. dollar) exchange rate is $1.20000. 12,000 USD is the cost to buy 10,000 euros, according to the current exchange rate. Assume the investor purchases 10,000 euros for 12,000 USD and holds the euros for one month, at which time EUR/USD trades to $1.21000 (100-pip advance). Should the investor sell the 10,000 euros at $1.21000, a 100 USD gain is realised (minus commissions). Notice that this is an unleveraged transaction and the pip value was 1 USD per pip. This pip value is identical to a U.S. investor that trades on margin. In this case, the trader enters long (buy) EUR/USD ($1.20000) using one mini lot (10,000 units of the base currency [mini lot]). The trader then liquidates the position at $1.21000 for a 100 USD gain (minus commissions).

• Account currency denominated in the same currency as the currency pair’s base currency:

(One Pip / Exchange Rate) * Trade Size

Trading EUR/USD with a euro-based account, for example, the trader (or investor) would need the pip movement value for euro in terms of USD: the term currency. Thus, when the term currency moves from, say, $1.20000 to $1.20100 (10-pip advance), the trader understands the USD equivalent in euro.

To explain, for the EUR/USD trading at $1.20000, market participants know that 1 euro is equivalent to 1.20 USD. To understand the euro pip value equivalent, as shown in the formula above, divide the pip value (0.00010) by $1.20000 to equal 0.00008333333 (euro pip value), and subsequently multiply the value by trade size. If the trade size is 10,000 units, the pip value for the current example is:

0.83 euro per pip = (0.00010 / 1.20000) * 10,000 (mini lot size)

• Account currency denominated in a currency not associated with the currency pair of interest

(One Pip / Conversion Exchange Rate) * Trade Size

At times, traders must compute the pip worth of a position that exhibits no direct relationship between the account currency and the currency pair.

The trick is to remember that the base currency of a currency pair is a whole number (an integer). It is the term currency that moves (decimal form) and is the price change visible on the y-axis of charts.

As an illustration, a trader works with an account denominated in British pounds (GBP) and the currency pair traded is USD/CHF (U.S. dollar against the Swiss franc). Here, the trader must find the GBP pip value in CHF as GBP is the account currency and CHF is the term currency of the currency pair traded. Therefore, the conversion exchange rate used in this case is GBP/CHF (British pound versus the Swiss franc). Consequently, if CHF moves 1 pip higher, the trader must recognise the equivalent value of a pip in GBP.

Assuming the trader works with a trade size of 10,000 units, the pip value in GBP, as per the formula above, is as follows:

0.80 GBP per pip = (0.00010 / GBP/CHF [CHF 1.24960]) * 10,000 units (mini lot size)

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