Forex trading is one of the most popular forms of investment in the world today. It is a decentralized market where individuals and institutions trade currencies from around the world. The goal of forex trading is to make a profit by buying and selling currency pairs. One of the most important concepts in forex trading is pips. In this article, we will explain what pips are and why they are essential in forex trading.
What are Pips in Forex Trading?
Pips stand for “percentage in point” or “price interest point.” It is the smallest unit of measurement in forex trading, representing the change in value between two currencies. Pips are used to measure the difference between the bid price and the ask price of a currency pair. The bid price is the price at which a trader can sell a currency, while the ask price is the price at which a trader can buy a currency.
For example, if the EUR/USD currency pair is trading at 1.1030, and it moves up to 1.1033, the change in the value of the currency pair is three pips. The first two digits represent the whole numbers, while the third digit represents the pip.
Why are Pips Important in Forex Trading?
Pips are important in forex trading because they determine the profit or loss of a trade. A trader’s goal is to make a profit by buying a currency pair at a low price and selling it at a higher price. The difference between the buying price and the selling price is the profit or loss.
For example, suppose a trader buys one lot of the EUR/USD currency pair at 1.1030 and sells it at 1.1033. If the lot size is 100,000 units, the profit would be calculated as follows:
Profit = (Selling Price – Buying Price) x Lot Size
Profit = (1.1033 – 1.1030) x 100,000
Profit = 3 pips x 100,000
Profit = $30
In this example, the trader made a profit of $30. However, if the trader had sold the currency pair at 1.1027, the loss would have been $30.
Pips also determine the risk-reward ratio of a trade. The risk-reward ratio is the ratio of the potential profit to the potential loss of a trade. For example, if a trader places a stop loss at 20 pips and a take profit at 40 pips, the risk-reward ratio would be 1:2. It means that the potential profit is twice the potential loss.
How to Calculate Pips?
Pips are calculated using the following formula:
Pips = (Change in Price / Exchange Rate) x Lot Size
For example, suppose the USD/JPY currency pair is trading at 109.20, and it moves up to 109.50. If the lot size is 100,000 units, the change in price is 30 pips, and the exchange rate is 1 USD to 109.20 JPY, the calculation would be as follows:
Pips = (30 / 109.20) x 100,000
Pips = 27.43
In this example, the change in price is 30 pips, but the calculation shows that it is 27.43 pips. The reason is that the exchange rate is not one-to-one. One USD is equivalent to 109.20 JPY, so the calculation needs to take into account the exchange rate.
Conclusion
Pips are an essential concept in forex trading. They represent the smallest unit of measurement in forex trading and determine the profit or loss of a trade. Pips also determine the risk-reward ratio of a trade. Understanding pips is crucial for forex traders to make informed trading decisions.
