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Trading in the financial space requires a clear understanding of the market and the terminologies used. Pips are among the most common terms you will meet in trading. Although they are commonly applied in forex trading, they can also be used in other forms of derivatives trading. So, what exactly are pips, and how are they used in trading?
If you are getting started with trading, reading this ultimate guide will enlighten you on everything about pips in trading. From understanding what they are to their pros and cons, we are here for you.
In This Guide
What is a Pip?
Before we discuss how pips are used in trading, let’s first answer one of the commonly asked questions by traders: “What are pips?” In forex trading, a pip measures the smallest movement of value in currency pairs. It stands for “percentage in point” or “price interest point.” Pips help traders calculate their potential gains or losses through spreads between the bid and ask prices.
Simply put, a pip is not a value on its own but is used to measure the movement of a financial instrument. Every pip move that favours you means a profit, while the one against you translates into a loss. They are used to set a spread of a specific asset to ensure you plan and budget accordingly.
How Are Pips Used?
As mentioned earlier, pips are used in forex trading and present the smallest price change in a currency pair. A pip is priced out to the fourth decimal place and is equivalent to 1/100 of 1% or one basis point.
For instance, if the EUR/USD pair moves from 1.1050 to 1.1051, that represents a one-pip movement. This applies to all currency pairs except those involving the Japanese yen (JPY). The JPY currency pairs are quoted to two decimal places. When calculating a pip in forex trading involving a currency pair like USD/JPY. In this case, focus on the second digit after the decimal point.
Let’s say a Japanese Yen currency pair moves from 120.03 to 120.04. In this case, understand that it is a single pip movement. Therefore, if you enter a position on a pair involving this currency and close the trade when the price reaches 120.23, your profit would be 20 pips (120.23 – 120.03).
Overall, it is crucial to understand the value of a pip in a currency pair. This is because it represents how the value of a currency pair fluctuates. As a result, you will be able to easily track your positions and know how they affect your profits or losses. Plus, pips will help you set risk management controls like stop-loss and take-profit orders.
How to Calculate the Value of a Pip
The value of a currency pair varies depending on which currency pair or trade size you are exploring. It all depends on which currency is the base and which one is the quote/counter. For instance, in the EUR/USD currency pair, one pip is valued at 1 USD per 10,000 EUR traded. The quote currency pip is fixed at 0.0001.
To calculate the pip for this currency pair, you will calculate the trade value/lot size by 0.0001.
Pip Value = Value Traded x Quote Currency Pip
$1 = 10,000 x 0.0001
In instances where the USD is the base or first of the currency pair. In this case, you may convert the pip value into your base currency using the exchange rate. You will divide the size of a pip by the exchange rate, then multiply with the trade value or lot size.
Let’s look at the USD/CAD currency pair, for example. If the exchange rate is at 1.3601. In this case, you will calculate the pip value by dividing 0.0001 by the exchange rate. You will then multiply the results by the standard lot size (say 100,000 USD bought against the CAD at 1.3601 and sold at 1.3602).
Pip Value = Trade Value (Pip Size ÷ Exchange rate)
$7.3524 = 100,000 (0.0001 ÷ 1.3601)
Your profit in the trade above will be 1 pip or $7.35.
When it comes to currency pairs involving the Japanese Yen, they are quoted in two decimal places. In a USD/JPY currency pair, the value of a pip is at 1/100 divided by the exchange rate. Therefore, if this forex pair is quoted as 140.53. In this scenario, one pip will be 0.01 ÷ 140.53 = 0.00007116. When multiplied by a lot size of 100,000 USD, the pip value will be $7.12.
How are Pips Used
Pips are used in various ways when it comes to managing trades in a currency market. They are applied in every position you open and close. As a trader, understanding how pips are used will help you approach trading strategically while maximising your experience. Here’s how pips in trading are used.
- Calculate a Trade’s Value
As mentioned earlier, pips are used to measure a trade’s value. A pip itself doesn’t have a value, but it is determined by a particular trade and the currency exchange rate between a forex pair you are exploring.
- Determine Profits or Losses
Besides measuring a trade’s value, you can use pips to calculate potential profits or losses. This will help you strategise and budget for your next activity. Plus, it will be easier to track your activities and learn from your mistakes.
- Setting Risk Management Controls
Risk management controls like stop-loss orders allow you to mitigate the amount of loss you may incur in case a trade works against your strategy. Using pips, it’s easy to set your limits so your positions can close at the right anticipated time.
- Imposing Spread
While pips are beneficial to traders, they also help brokerage firms set spreads for forex trading activities. Plus, it will be easier for them to adjust the spreads to the current value of the instruments being explored.
Pros and Cons of Using Pips in Trading
Pips in forex trading carry numerous benefits rather than drawbacks. As a trader, understanding these pros and cons will help you find the right trading approach. Here’s what you need to know.
Pros:
- With pips, you will have a clear understanding of the price movements in the financial markets. With a standardised measurement unit, you can easily gauge a trade’s profitability.
- There is flexibility in trade size with pips. You can choose to trade in mini-lots, micro-lots, or standard lots. It all depends on your risk appetite and account size. Simply put, pips encourages even low-budget traders to explore various currency pairs.
- When using pips as a measurement, it’s easy to set specific levels for stop-loss and take-profit orders. This will help you limit potential losses and secure profits.
- Pips make it easier for a trader to calculate the risk-reward ratio before opening a position. You will assess the viability of a trade, thus protecting your overall trading capital.
Cons:
- During periods of volatility, using pips to identify the right exit and entry points can be challenging. Therefore, it is essential to be cautious during such periods, as any wrong move may result in losses.
- Pips can frustrate traders expecting huge profits from trade. They mainly focus on small price movements.
- The small price movements in pips can lead to impulsive trading decisions. This is especially for those who do not know how to manage their emotions and look forward to earning quick profits.
FAQs
How much is 10 pips worth in forex?
The value of 10 pips depends on the currency pair and trade size. For instance, if you are trading the EUR/USD pair with a standard lot size (100,000 units). In this case, a single pip would be worth approximately $10 (0.0001 x 100,000). Therefore, 10 pips would be worth $100. For smaller trade sizes, like mini or micro-lots, the value of 10 pips would be smaller. This would be around $10 for mini-lots and $1 for micro-lots.
How do pips relate to profit and loss in trading?
Pips are directly tied to profit and loss in forex trading. They represent the difference in the number of pips between the entry and the exit price. Simply put, pips determine how much profit or loss a trader has made. For example, if a trader buys EUR/USD at 1.1100 and sells it at 1.1120, they gain 20 pips. If they traded one standard lot, that would result in a $200 profit. But, if the price moves in the opposite direction. In this case, you will incur a 20-pip loss, equating to $200 lost for a standard lot.
Why are pips important for traders to understand?
Pips are the foundation of calculating profits, losses, and overall trade performance. Since they represent the smallest measurable movement in currency pairs. In this case, they help gauge the potential impact of market movements on their trades. Without this knowledge, you wouldn’t understand how much you stand to gain or lose in any given trade.
What is the difference between a pip and a pipette?
A pipette is a fractional pip, typically representing one-tenth of a pip. In forex, pipettes are displayed as the fifth decimal place in most currency pairs. For example, if EUR/USD moves from 1.10503 to 1.10504, that movement is one pipette. They are also shown as the third decimal place in pairs involving the JPY. Pipettes provide more precision for traders. This is in high-frequency trading strategies where very small price movements are crucial.
Conclusion
Understanding pips in forex trading is crucial. Remember, they serve as a universal unit of measurement for price movements in currency pairs. Whether you are managing risk or setting take-profit or stop-loss levels. In this case, pips will help you make the best decisions. You can also apply them in tracking profits and losses for effective planning.
We understand that this concept may seem complex at first. This is especially when factoring in different pip values across currency pairs and trade sizes. However, mastering this element of forex trading can significantly improve decision-making. Overall, pips help maintain clarity, consistency, and precision when making trading decisions. Although there are some pitfalls to pips in trading, the advantages far outweigh the disadvantages.
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