Forex – Some facts you need to know
We are not going to go into immense detail, but if you intend trading Forex, there are a few things you will find useful to know. The term ‘Forex’ is an abbreviation of ‘foreign exchange’, often further abbreviated to ‘FX’. Currencies are always traded in pairs, which are defined as the ‘base’ and the ‘quote’. For example, in the USD/EUR pair, USD is the base currency and EUR is the quote currency.
At the time of writing, there are 154 currencies available on the Forex market. Currency pairs are further defined into three groups: Major, Minor and Exotic. Major currency pairs always include USD. Minor pairs do not include USD and usually include another Major currency, often EUR or GBP, but not always. Exotic pairs consist of one less-stable currency paired with a Major currency, mostly USD, EUR and GBP.
One currency is always relative to another in the Forex marketplace. If you enter an ‘ask’ (buy) trade then you are selling the opposing currency. If you take a ‘bid’ (sell) trade, you are buying the opposing currency. Your trading profit or loss is then calculated using the spread difference in price movement between the two currencies at the end of the trading period, which is defined in pips.
What is a Pip in More Detail
You will find the term ‘pip’ defined in one of two ways, depending on where you are trading. Most commonly as a ‘percentage in point’ and occasionally as the ‘price interest point’ but they are exactly the same.
A pip is the smallest price movement recorded in Forex, representing a unit that equates to 1/1000th of a currency, or 0.0001. Whenever you see a Forex quote, it will be represented in a decimal format, with either four or five numbers after the decimal point. The fourth number represents whole pips and the fifth is a fraction of a pip.
Pip is the correct term to describe price movements in the Forex market, but there are a few brokers who use the term ‘tick’ instead, you can read more about that in our how to buy stocks guide. It does mean exactly the same, but is more appropriate to the stock market than to Forex.
What is a Pip in Forex? – Standard Currency Pairs
It is easiest to start here with a really simple example. A product in a shop is priced at $1.50 with only two decimal places being used to define its value. However, four decimal places are used for Forex, so the same amount would be quoted on the Forex markets at 1.5000. It is always the fourth decimal place that represents the number of pips.
A single pip therefore has a value of 0.0001, which is 1/100th of 1%.
A value of 0.0005 would represent 5 pips or 5/100th of 1%.
What is a Pip in Forex when you trade Japanese Yen?
Here comes the exception to the standard definition of a pip in Forex terms. Because the Yen is such a low value currency (there is only about 100 JPY to $1) price quotes only go to two decimal points. That is 0.01 or 1/100th of a yen rather than the usual 1/1000th shown for all other major currencies.
However, as all other currencies adhere to the standard definition of a pip, the examples in our guide will reflect the standard value of a pip as 0.0001.
What is a Pip in Forex and how to calculate its value?
To calculate the value of a pip, for a specific trading position, there are three factors to consider: the pip size, the exchange rate and size of the trading position.
The calculation is then made using this formula:
Pip value = (pip size / exchange rate) x position size
The pip size is 0.0001. The exchange rate for the two currencies is indicated by the ‘spot value’ and the position size represents the amount of currency you have selected.
Example: $100,000 with a spot value of 1.14067 trading EUR/USD
Pip value = (0.0001 / 1.14067) x 100,000
Pip value = €8.7667
Note: In the EUR/USD pair EUR is the base currency and USD the quote currency. The pip value is always defined in the base currency, in this case EUR.
If your account is held in a different currency to EUR, then you will need to convert the pip value into your own currency. As this is a fairly complex process, brokers usually provide an online calculating facility to speed the process for you.
Why is it so important to know the Pip value?
All of that calculating really is an essential part of Forex trading and it is important to learn the formula well enough to use it routinely. Knowing the pip value enables you to establish the level of risk exposure for any given trade. This can vary considerably depending on the volatility of the currency pairs involved.
If you are trading with leverage, then the pip value becomes even more important, as your profit or loss will be magnified and in a worst case scenario you could easily find yourself over-extended. You will find CFD leverage explained and its trading implications in a separate guide.
What is a Pip? – The facts about pips and leverage
It is common practice for Forex traders to use leverage. We are not going to explain exactly how it works here, as we have compiled a separate guide covering the subject of leverage in detail.
What you do need to be aware of is that pip value does not vary according to the ratio of leverage you use, but it is affected by the increase in your position size achieved by using leverage.
To explain this a little more clearly: in a potential trade you have calculated the pip value at €1 and your position size is €1000. If you use leverage at 10:1, then your position size increases to €10,000 and the pip value also rises to €10 per pip.
Effectively, the bigger your position size, the higher the pip value becomes and the potential profit or loss for the trade increases proportionally.
What is a Pip? – Other things you need to know
It might feel by now that the subject of Forex trading is a never-ending list of new terminologies and their level of importance. Forex is actually one of the most complex types of trading because it does involve grasping so many concepts and implementing them successfully to avoid losses – there really are no shortcuts to be made here!
To try and make it as straightforward as is realistically possible, there are four other terms you need to grasp:
The ‘spread’ is the difference between the ask (buy) price and the bid (sell) price, which is represented in pips. The spread is calculated using a simple subtraction:
Ask price – Bid price = Spread
Exchange rates for the two currencies in a Forex pair are quoted to five decimal places; the fourth digit after the decimal point represents whole pips and the fifth digit, the remaining proportion.
Here are two examples:
Ask price 1.13467 – Bid price 1.13457 = 0.0001 or 1 pip
Ask price 1.13467 – Bid price 1.13452 = 0.00015 or 1.5 pips
Brokers may describe the fifth digit in any one of three different ways: a ‘point’, a ‘fractional pip’ or in some cases as a ‘pipette’.
Orders form an essential part of your trading strategy and are used to minimise losses and maximise profits. The main ones you need to know about are:
- Stop- Loss
- Take Profit
- Trailing Stop
We are not going to explain them all in detail, but the reason we have mentioned them here is because pips are used as either a pre-determined denominator, or to perform a risk calculation for a trade. For example, Take Profit is often used in conjunction with Stop Loss, with the ratio of pips between one and the other used to determine your risk/reward ratio.
There are three types of quote. A ‘Direct Quote’ defines how much of your native currency is required to purchase a single unit of a foreign currency. For example, if your native currency is USD, in a USD/EUR currency pair, a direct quote will give you the amount of USD needed to buy a unit of EUR. An ‘Indirect Quote’ reverses that principle and a ‘Cross Currency’ quote involves two currencies, neither of which are your native currency.
Suffice to say that specifically within the Forex trading environment you can use lot sizes smaller than a standard lot which is 100,000 units of currency. Forex brokers also offer Mini lots (10,000 units), Micro lots (1,000 units) and Nano lots (100 units).
If you want to learn more about lots and lot sizes, which is especially important for trading the best dividend stocks we have created an in-depth guide entirely dedicated to that subject.
What is a Pip in Forex? – Using pips to assess your trading success
You will often see online traders expressing how successful (or not) they have been in terms of how many pips they have ‘made’ or ‘lost’ on that day. There are also many online websites that offer trading systems with titles like ’Make 10 pips every day guaranteed’, which are frankly best ignored altogether.
The terminology they are using relates to the outcome at the end of a trading day, which you can determine by comparing profitable trades against losing trades and expressing the result in pips. If you actually want to know how much money you have earned, then a different formula is used.
What is a Pip in Forex? – Using pips to calculate your profit
We hope that your calculators have not overheated yet, as there is more maths coming up. You can use pip movement to calculate the profit or loss for a given trade. It would be true to say that many Forex brokers have a trading platform online gizmo to do this for you, but learning how to do it for yourself is not just useful, it will also increase your understanding of the risk exposure for every trade.
This is how you calculate it:
Bid price of Base currency – Ask price of Base currency x Position Size = Profit or Loss
Bid price €1.2177 – Ask price €1.2167 x Position 100,000 = €100.00
In the example above, your profit would be €100.00. However, if the figures for the Bid and Ask were reversed, then it would indicate a loss of €100.00.
As we have shown you throughout this guide, it is not the difficulty level of the calculations themselves, it is more about knowing which factors you use to get the right answer.
Conclusion – What is a Pip?
Now that you have made it to the end of this guide, we hope you have a much clearer understanding of the role of pips in a trading environment. One of the most vital skills you will have learned is how to calculate the pip value before you enter a trade and how to use it to assess your risk exposure.
You should also have a clearer idea of how a small pip movement can have a huge impact on an individual trade. The information we have compiled in this guide is only a brief glimpse into the intricacies of Forex trading. To continue your education and understand more trading terminology, please take time out to read our other trading guides covering lots, leverage and trading platforms.
What is a Pip? FAQs
❓What does pip mean?
The word pip is an acronym for ‘percentage in point’ and is usually associated with Forex trading. You can learn everything you need to know about pips and their role in Forex by reading our guide, which you can find here at TradersBest.
👀What is a pip in Forex?
A pip represents a tiny unit of currency, but there is much more to know about pips than that fact. You can find all of the information you need by reading our in-depth trading guide to pips in Forex, plus many more trading-related subjects here at TradersBest.
💹How many pips are in a Forex spread?
A spread represents the gap between two currency exchange rates. You need to know how to calculate the pip value for every Forex trade you enter. You can find out how to do that by reading our pip guide and learn all about other trading terminologies by visiting TradersBest.
💲What Is 10 pips worth?
A single pip is 1/1000th of 1% of a currency, but the value of that in monetary terms has to be calculated. Learn how to do that and explore other important Forex facts by reading our in-depth guides and broker reviews here at TradersBest.
🎓What does pip profit mean?
Some Forex traders use that term in regard to the ratio of profit and loss, expressed as a number of pips. However, if you want to know your profit in monetary terms, then there are several Forex-related fundamentals to understand first. You will find everything you need to know in our pip guide, which you can access here at TradersBest.