Brief overview: A pip is the smallest price change that an exchange rate can make. Most currency pairs are priced to four decimal points, meaning that the smallest change that can be calculated is one hundredth of a per cent. This is also known as a basis point, hence where the term ‘per point’ comes from. The EUR/USD will trade to four decimal places, however the USD/JPY only trades to three decimal places.
Full overview: Understanding the meaning of pips, as a part of the basic forex trading terminology, forms the basis of successful trading. Here, we’ll cover that a pip is and how to calculate its monetary value. Also, there are some handy risk management tips that will help you keep your losses under control, all with the use of pips!
How Currencies Are Quoted
Before we dig deeper into the world of pips, let’s start with the basics first. To properly understand the meaning of pips, you need to get acquainted with how currencies are quoted.
In the forex market, currencies are always quoted in pairs. Examples are EUR/USD (euro vs US dollar pair), GBP/USD (British pound vs US dollar pair), and AUD/JPY (Australian dollar vs Japanese yen pair), to name a few. As you can notice, each pair consists of two currencies: The base currency and the counter currency. The base currency is the first currency in the pair (e.g. euro in the EUR/USD pair), and the counter currency is the second currency in the pair (e.g. US dollar in the same pair.)
By convention, the exchange rate of a currency pair always represents the price of the base currency in terms of the counter currency. For example, if the EUR/USD pair is currently trading at 1.1050, this means that one euro costs $1.1050 to buy, or it takes $1.1050 to buy one euro.
The EUR/USD pair is an example of a major pair because it includes the US dollar as the counter currency. Any pair that includes a major currency and has the US dollar as either the base currency or the counter currency is called a major pair, such as GBP/USD, USD/JPY, or AUD/USD, for example.
Besides those pairs, there are also cross-pairs that include any two major currencies except the US dollar.
Examples of cross pairs include EUR/JPY, AUD/NZD, and CAD/CHF, to name a few. To recall, major currencies in the forex market include the US dollar, Canadian dollar, British pound, euro, Swiss franc, Japanese yen, Australian dollar, and New Zealand dollar. If we include all G10 currencies, then the Swedish krona and the Norwegian krona can also be considered major currencies.
Position Sizes in Forex
Since the value of a single pip depends on the position size we take, it’s important to understand the concept of position sizes in trading. You’ll deal a lot with position sizes in your daily trading activities in order to control your risk and determine your risk per trade.
In the forex market, position sizes are expressed in so-called lots. One standard lot equals to a position size of 100.000 units of the base currency.
Later in this article, we’ll explain how to use position sizing and pips in risk management.
Now that you know how currencies are quoted and what position sizes represent, it’s time to explain the meaning of pips. In forex, a pip is the smallest increment that an exchange rate can change. For most pairs, one pip represents the fourth decimal place in the exchange rate.
Some currency pairs have a slightly different meaning of a pip. In most JPY pairs, one pip represents the second decimal place. For example, if the USD/JPY pair moves from 108.70 to 108.90, this would be a change of 20 pips. Similarly, a fall from 108.90 to 108.10 would represent a fall of 80 pips.
It’s important to have a crystal clear understanding of pips because many traders use pips to determine their profit or loss of a trade. That’s why you’ll frequently hear “I made 200 pips today”, or “Last week I lost only 40 pips.”
Pip vs Pipette
Another measure of exchange rate movements are pipettes. Unlike pips, which are placed on the fourth decimal place of an exchange rate, pipettes are placed at the fifth decimal place. This means that 10 pipettes form a pip, or one pipette has a value of one-tenth of a pip.
While pipettes are not that frequently used, some brokers still display their currency quotes with five decimal places, making it important to understand the difference between pips and pipettes. Pipettes are also used in the calculation of spreads.
Calculating the Value of a Pip
The value of a pip depends on the position size of your trade. In short and as a rule of thumb, a position size of one standard lot has a pip-value of around $10.
This way, it’s easy to calculate the pip-value for different position sizes. For example, a position of 0.1 lots in the EUR/USD pair (i.e. 10.000 euros) will have a pip-value of $1. This means that a rise in the exchange rate from 1.1050 to 1.1070 equals a monetary value of $20.
The value of a single pip depends on the counter-currency of a pair.
Let’s take another currency pair for example. If you buy 0.50 lots of AUD/CAD, this represents a position size of 50.000 Australian dollar. If the current exchange rate is 0.9020, this means that 50.000 Australian dollars are worth 45.100 Canadian dollars at the time of execution.
Let’s say the exchange rate rises to 0.9060 – Now, 50.000 AUD would be worth 45.300 Canadian dollars. Those 40 pips of profit would be worth 200 Canadian dollars, returning a pip-value of 5 Canadian dollars per pip. In other words, 0.50 lots in AUD/CAD carry a pip-value of C$5.
Spread and Pips
As noted earlier, spreads are expressed in pips and pipettes in the forex market. The spread of a currency pair represents the difference between the buying and selling price of the pair. From a trader’s perspective, the buying price is always higher than the selling price, with the difference between those two prices being the profit of the broker.
With the high competition between forex brokers and the high liquidity of the forex market (the most liquid financial market in the world), spreads are usually quite tight. In major pairs, such as EUR/USD, it’s not unusual to see spreads as low as 1 pip or even lower. This means that opening and closing a EUR/USD trade would cost you a total of 1 pip.
Pipettes are also often used in spreads. A spread of, let’s say, 2.2 pips means that you’re paying 2 pips and 2 pipettes to open a trade in that pair. And now that you know how to calculate the value of a single pip, it’s easy to find out how much money in trading costs you’re paying.
Pips and Risk Management
Pips are also playing an important role in risk management. Before placing a trade, you should determine your total risk that you’re willing to take on the trade. Let’s say you don’t want to risk more than 2% of your trading account on a trade, i.e. $200 on a $10.000 account.
After you determine your total risk per trade, it’s time to identify suitable technical levels for your stop-loss, such as around an important support and resistance level. In this step, you need to determine the size of your stop-loss in pips. Let’s say your stop-loss is placed 50 pips from your entry price.
Now that you have all the needed variables, it’s easy to determine your position size by calculating the maximum pip-value you can trade to stay inside your risk-per-trade boundaries. To risk $200 with a 50-pips stop-loss, each pip shouldn’t exceed $4. In the EUR/USD pair, for example, that would equal a position size of €40.000 or 0.4 lots.
- Currencies are quoted in pairs, where the first currency is called the base currency, and the second currency the counter currency.
- The exchange rate of a currency pair represents the price of the base currency expressed in terms of the counter currency.
- One standard lot in the forex market equals to 100.000 units of the base currency.
- A pip is the smallest increment an exchange rate can move. It’s the fourth decimal place of the exchange rate.
- Pipettes are even smaller than pips. They equal one-tenth of a pip. However, pipettes are rarely used by traders, except in the calculation of spreads.
- The monetary value of a pip depends on the counter currency. E.g., one standard lot in the EUR/CAD pair carries a pip-value of 10 Canadian dollars.
Pips are the smallest increment that an exchange rate can move. Pips also play a vital role in your risk management, which is why understanding pips and other basic forex terminology forms the foundation of a successful trading career.