Foreign exchange (forex) trading is one of the most popular financial markets globally, with an estimated daily trading volume of over $5 trillion. The forex market is complex, and it can be challenging for beginners to understand the terminologies used. One of the most crucial terminologies in forex trading is pips. Understanding pips is essential because it determines how traders make profits or losses. In this article, we will explain what pips are and how to understand them in forex trading.
What are Pips?
The term “pip” is an abbreviation for “percentage in point” or “price interest point.” A pip is the smallest unit of price movement in forex trading. It represents the fourth decimal place in a currency pair’s price, except for currency pairs that involve the Japanese yen, where one pip is the second decimal place. For example, if the EUR/USD currency pair moves from 1.2000 to 1.2005, it has moved five pips. Similarly, if the USD/JPY currency pair moves from 109.50 to 109.55, it has moved five pips.
Pips are crucial because they determine the profit or loss made in a forex trade. Forex traders make profits by buying a currency pair at a lower price and selling it at a higher price or by selling a currency pair at a higher price and buying it at a lower price. The difference between the buy and sell price is called the spread. The spread is measured in pips, and it represents the cost of the trade. Therefore, the profit or loss made in a forex trade is determined by the number of pips the currency pair moves and the size of the trade.
Understanding Pip Value
To understand how pips affect profits and losses, we need to understand pip value. Pip value is the monetary value of one pip in a forex trade. The pip value varies depending on the currency pair, the size of the trade, and the currency denomination of the trading account. To calculate the pip value, we need to use the following formula:
Pip Value = (Pip in decimal places / Exchange rate) x Trade size
For example, if we want to calculate the pip value of a EUR/USD currency pair with an exchange rate of 1.2000 and a trade size of 10,000 units, the pip value would be:
Pip Value = (0.0001 / 1.2000) x 10,000 = $0.83
Therefore, every time the EUR/USD currency pair moves one pip, the trader makes or loses $0.83 depending on the direction of the trade.
Understanding Pipettes
Pipettes are another important aspect of pip measurement in forex trading. Pipettes are fractional pips, and they represent the fifth decimal place in the currency pair’s price. Some forex brokers quote prices in pipettes to provide a more accurate price representation. For example, if the EUR/USD currency pair moves from 1.20000 to 1.20005, it has moved five pipettes or half a pip.
Calculating Profits and Losses in Pips
To calculate the profit or loss in pips, we need to know the entry and exit price of the trade, the direction of the trade, and the size of the trade. The profit or loss in pips is calculated using the following formula:
Profit/Loss in pips = (Exit price – Entry price) x Direction x Trade size
Direction is either 1 for a long trade (buy) or -1 for a short trade (sell). For example, if we enter a long trade on the EUR/USD currency pair at 1.2000 and exit the trade at 1.2020 with a trade size of 10,000 units, the profit in pips would be:
Profit in pips = (1.2020 – 1.2000) x 1 x 10,000 = 20 pips
If the trade direction was short, the calculation would be:
Profit in pips = (1.2000 – 1.2020) x -1 x 10,000 = 20 pips
Conclusion
Pips are a crucial aspect of forex trading, and understanding them is essential for successful trading. Pips represent the smallest unit of price movement in forex trading, and they determine the profit or loss made in a trade. Pip value is the monetary value of one pip, and it varies depending on the currency pair, the size of the trade, and the currency denomination of the trading account. Pipettes are fractional pips, and they represent the fifth decimal place in the currency pair’s price. Calculating profits and losses in pips requires knowing the entry and exit price of the trade, the direction of the trade, and the size of the trade. By understanding pips, traders can make informed trading decisions and manage their risk effectively.
