This post will explain what Pips are, how they work, and why they are essential for traders, especially beginners.
In the world of forex trading, much of your potential for success will revolve around your understanding of the terminology.
Perhaps one of the most basic terms you will encounter is the term Pips.
Let’s dive right in.
What is a Pip?
A pip is an abbreviation for “percentage in point” or “price interest point.”
It is the smallest price move that a given exchange rate can make based on market convention.
For most currency pairs, one standard pip is equal to 0.0001.
However, for those currency pairs that contain the Japanese yen (JPY), one pip equates to 0.01.
For example:
– If the EUR/USD moves from 1.1050 to 1.1051, it has moved 1 pip.
– Conversely, if the USD/JPY moves from 110.00 to 110.01, it has also moved 1 pip.
Pips must be understood properly because they give traders a means to measure movement for pricing and potential profit or loss computation.
Why Are Pips Important?
Pips serve many important purposes in forex trading:
1. Measuring Price Movements
Pips allow the standard measurement of price change in currency pairs.
The ability to measure then allows traders to convey information about price movements to each other without misunderstandings.
For example, if someone says, “The EUR/USD moved 50 pips higher,” there is instant clarity as to the amount of movement.
2. Calculating Profit and Loss
Pips are what traders use to calculate profit and loss on trades.
Suppose you buy one standard lot (100,000 units) of EUR/USD and the price moves up 50 pips; this is how you will calculate your profit:
Profit = Pip Value x Number of Pips
One pip in a standard lot in EUR/USD is approximately worth $10.
Thus,
Profit = 10 × 50 = $500
3. Risk Management
It helps traders understand pips, whereby traders can manage their risk effectively.
This is because they know how much profit or loss they will make per pip, using appropriate stop-loss and take-profit orders.
Calculating Pip Values
The value of a pip depends on the currency pair being traded and the size of the trade or lot size.
The following is how you go about the calculation:
For Major Currency Pairs, such as the EUR/USD
The formula for calculating the pip value in major currency pairs is:
Pip Value = One Pip / Exchange Rate x Lot Size
As an example, if you are trading one standard lot of 100,000 units of EUR/USD at an exchange rate of 1.1050, the value of one pip will be:
Pip Value = 0.0001 / 1.1050 x 100,000 ≈ $9.05
Currency Pairs Involving JPY
For pairs like the USD/JPY, where one pip is equal to 0.01, the calculation slightly changes:
Pip Value = One Pip / Exchange Rate x Lot Size
If, for example, one is trading one standard lot of 100,000 units of the USD/JPY at an exchange rate of 110.00, the value of the pip would then be:
Pip Value = 0.01 / 110.00 x 100,000 ≈ $9.09.
Types of Lots in Forex Trading
There are particular sizes in which forex trades are executed, and these are termed lots:
– Standard Lot: 100,000 units of currency.
– Mini Lot: 10,000 units.
– Micro Lot: 1,000 units.
– Nano Lot: 100 units (less common).
Understanding these lot sizes is important because they in turn help you understand just how much you will gain or lose per pip.
Common Misconceptions About Pips
1. All Currency Pairs Use the Same Pip Value
While most of the major pairs have a pip value of 0.0001, not all currencies are like that, especially those involving the JPY, in which a pip is 0.01.
2. Pips Are Fixed
The value of a pip can change based on market conditions and exchange rates; therefore, it’s crucial to calculate it before placing trades.
Practical Example: Trading with Pips
Let’s consider an example for a practical understanding of how pips work.
Suppose you open a trade on the EUR/USD pair:
1. You buy one standard lot, buying it at an exchange rate of 1.2000.
2. The price goes up to 1.2050, moving 50 pips.
3. Since we estimated earlier that one pip of a standard lot is worth $10, your profit will be:
Profit = 50 × 10 = $500
If the price had fallen to 1.1950, your loss would have been:
Loss = 50 x 10 = $ 500
This example highlights how understanding pips can significantly impact your trading outcomes.
Conclusion
Pips are the basics of Forex trading.
They are a kind of measuring scale or unit that determines a particular amount of movement in the prices of currencies.
This is used to calculate the profit of a trade.
Mastering this can yield better returns as it helps in framing better trading strategies and managing risks accordingly.
As you begin to trade in forex, remember that any successful trader can always learn to trade and read the market movements through pips.
By learning this concept and then applying it in your strategy, you should be able to trade forex with a great deal of confidence.
