As you know, the secret to successful forex trading is buying a currency pair at a lower price than you eventually sell it for.
The unit of measurement used to calculate the shifts in value are called pips, and this p-word will become an integral fixture in your life if you intend on becoming a forex trader in the long term.
So here’s a quick overview of everything you need to know about pips in forex trading.
What are pips?
Each foreign currency pair is traded to several decimal places, and it’s the final number of this sequence that is the most relevant ‘pip’ in trading, with pip standing for ‘percentage in point’ or ‘price in point.’
The best forex brokers typically display four decimal places in their pairs, and so if – for example – USD/GBP traded from 1.3271 to 1.3272, this would be a move of one pip. If it increased from 1.3272 to 1.3280, that would be a move of eight pips and so on.
Occasionally, your forex broker may quote prices that go beyond this accepted four decimal place measure; perhaps five or even six numbers after the point will be used. In this case, they are referred to as ‘pipettes,’ ‘points,’ or ‘fractional pips.’
While the process can change, the fourth decimal place is a single-digit pip. The third decimal place is tens of pips (so a 4 would be 40 pips), the second decimal place is hundreds (so a 2 equals 200), the first decimal place is thousands (8 -> 8000), and the figure before the decimal point is ten thousands (5 -> 50,000).
So, if the price of USD/GBP went from 1.3272 to 1.3372, this would be a move of 100 pips.
Why are pips important to traders?
As we have learned, pips measure the change in the price of a particular currency pair.
To that end, pips also define the gap between the buy and the sell price of a forex asset – this spread is vital to traders in determining the profitability that will be realized by opening or closing a position at any given time.
When trading particularly volatile currencies, like the Russian Rouble at the moment, it is also essential that you enter and exit the market quickly and clinically – understanding pip ranges is crucial.
So, let’s say you purchased GBP in a GBP/USD pair at 1.3271 and sold at 1.3281. You would realize a profit of 10 pips. Conversely, if you sold USD in the same equation, you would lose 10 pips if you closed at 1.3281 but gain 10 pips if you closed at 1.3261.
You might not think that the odd pip move makes a great deal of difference in the grand scheme of things, especially when you have deployed an automated trading bot or similar software. However, when you consider your overall profitability during a trading period, every pip of revenue can count.
If you are trading with a large bank, a 10-pip movement can be the equivalent of hundreds of dollars ‘won’ or ‘lost’ – so the importance of treating each pip with the attention it deserves is vital.
How to calculate pip value
If you want to dig a little deeper in your analysis of pip movements, you can analyze the relative value of each pip by carrying out a couple of quick calculations.
Let’s say we have $10,000 in an open USD/GBP position. During the next trading session, the value of this pair increases by 10 pips from 1.3271 to 1.3281. We can calculate our actual profit on the trade by calculating the following math:
1) Working out our skin in the game by multiplying our capital by the pip value. So, in this example, we have invested 10,000, and our pip value is 0.0001 – therefore, 10,000 x 0.0001 = £1 per pip (on the sell-side).
2) Now we know our GBP per pip value, we can exchange this figure to USD profit by dividing our GBP per pip ratio by the current exchange rate (1.3281). So, our calculation is 1/1.3281 = $0.75 per pip.
3) Now, we can work out our total profitability from the trade. So, we can multiply the number of pips gained by our USD per pip value. In this example, that is 10 x 0.75 = $7.50 profit.
This is a small-scale example as far as pip movement is concerned, but if we increase our gain to 100 pips, our profit becomes $75 on the trade, and so on.
Conversely, if you wanted to cut your losses on an opening position, you would use the same calculation but simply utilize a negative pip value when doing the math.
Knowing this calculation inside and out will help you determine when to open or close a position – timing is everything in forex trading.