In trading, a ‘pip’ is a very small price movement. The term is short for ‘percentage in point’. Traditionally, a pip is essentially the smallest move that a currency could make in forex trading. It is an important unit of measurement in the trading of currency pairs.
Traders use pips to measure price movements in currencies. Determining the number of pips in a certain price movement is a straightforward process, although it depends on the instrument traded.
In forex, the smallest price change is that of the last decimal point. Given that most major currency pairs, such as those involving USD, EUR and GBP, are priced to four decimal places, a pip in this scenario is a price movement of 0.0001. For example, if GBP/USD moved from 1.4000 to 1.4001, it has moved by one pip.
Comparatively, JPY currency pairs are only quoted to two decimal places. In this case, a pip is a price movement of 0.01. For instance, if GBP/JPY moved from 150.00 to 150.05, it has moved by five pips. Here are some examples of pips in forex trading.
If a trader entered a long position on GBP/USD at 1.5000 and it moved to 1.5040, the trader has made a profit of 40 pips. On the other hand, if the trader went long on GBP/USD at 1.5000 and the exchange rate fell to 1.4980, the trader has made a loss of 20 pips. Similarly, if the trader went long on GBP/JPY at 145.00 and it moved to 145.75, the trader has made a profit of 75 pips. If the exchange rate went against the trader, and GBP/JPY fell to 144.20, the trader has made a loss of 80 pips.
In CFD trading, a pip represents the minimum amount by which the underlying asset needs to change in value before the CFD changes in value. So, for a CFD on a US-listed stock, a pip might be $0.01. If a trader purchased a CFD on a stock at $5.00 and it moved to $5.10, that amounts to a profit of 10 pips.
Apart from measuring price movements and profit and loss, pips are also useful for managing risk in trading and for calculating appropriate amounts of leverage to use in trades. For example, a trader can use a stop-loss order to set the maximum amount he is willing to lose in terms of pips on a trade. Having a stop loss in place will limit losses if the trade moves in the wrong direction.
How to calculate the value of a pip and position size
How much profit or loss a pip of movement produces depends on the value of each pip. To calculate the value of a pip, we need to know the currency pair being traded, the trade amount and spot price.
The formula to calculate the value of a pip for a four-decimal currency pair is:
Pip value = (0.0001 x trade amount) / spot price.
Example 1
Let’s say a trader places a $100,000 long trade on USD/CAD when it is trading at 1.0548.
The value of USD/CAD rises to 1.0568. In this instance, one pip is a movement of 0.0001, so the trader has made a profit of 20 pips (1.0568 – 1.0548 = 0.0020 which is the equivalent of 20 pips).
The pip value in USD is (0.0001 x 100,000) / 1.0568 = $9.46.
To calculate the profit or loss on the trade, we simply multiply the number of pips gained, by the value of each pip. In this example, the trader made a profit of 20 x USD $9.46 = $189.20.
Example 2
Let’s say the trader places a $10,000 long trade on USD/CAD when it is trading at 1.0570.
The value of USD/CAD rises to 1.0600. In this instance, one pip is a movement of 0.0001, so the trader has made a profit of 30 pips (1.0600 – 1.0570 = 0.0030 which is the equivalent of 30 pip).
The pip value in USD is (0.0001 x 10,000) / 1.0600 = $0.94.
In this example, the trader made a profit of 30 x USD $0.94 = $28.20.
Pips can also be used in the calculation of position size. Position size is the size of one position within a portfolio.
In terms of risk management, calculating position size is very important. If a trader’s position sizes are too large and he experiences a number of losses, he may wipe out his capital. Therefore, trading with an appropriate position size is essential.
There are several steps involved in calculating position size.
First, the trader must determine the amount of capital in his account he is willing to risk per trade. For example, this might be 1% per trade. This means that the trader can make 100 trades before his capital is wiped out. If the trader’s account has a balance of $5,000 and he is willing to risk 1% per trade, this equates to $50 per trade.
Second, the trader can determine a stop loss in pips. For example, if the trader goes long EUR/USD at 1.3600, he could place a stop loss at 1.3550. This stop loss equates to 50 pips.
The last step depends on what lot size the trader is trading. A standard lot refers to 100,000 units of base currency and equates to $10 per pip movement. A mini lot is 10,000 units of base currency and equates to $1 per pip movement. A micro lot is 1,000 units of base currency and equates to $0.10 per pip movement.
Assuming a micro lot size ($0.10 per pip movement), the position size would be $50 / (50 pips x $0.10) = 10.
So the trader’s position size would be 10 micro lots.
Here is another example.
Let’s say a trader has an account balance of USD $5,000 and is willing to risk 1% of the account balance per trade. That means the trader can risk $50 per trade. The trader goes long EUR/USD at 1.1500 with a stop loss of 1.1420. That means the stop loss is 80 pips.
Assuming a pip value of $0.10, the position size is calculated as:
$50 / (80 pips x $0.10) = 6.25 micro lots. This is rounded down to 6 micro lots.
So, the position size is 6 micro lots.
What causes pip values to change?
The base value of a trader’s account will determine the pip value of many different currency pairs. For a USD-denominated account, if the currency pair has USD as the second (quote) currency, the pip value will always be $10 on a standard lot, $1 on a mini lot and $0.10 on a micro lot.
Pip values would only change if USD was either the first (base) currency in the currency pair, or not involved in the pair, and if the value of USD moved significantly by more than 10% up or down.
Summary
In trading, a ‘pip’ is a very small price movement. Traders use pips to measure price moves and to measure profit or loss. In the foreign exchange market, a pip is the smallest move that a currency can make.
Given that most major currency pairs are priced to four decimal places, a pip in this scenario is a price movement of 0.0001. For example, if GBP/USD moves from 1.5000 to 1.5010, this is a movement of 10 pips.
However, some currency pairs, such as those involving the Japanese yen, are only quoted to two decimal places. In this case, a pip is a price movement of 0.01.
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In CFD trading, a pip represents the minimum amount by which the underlying asset needs to change in value before the CFD changes in value. For a CFD on a US-listed stock, a pip might be $0.01.
Apart from measuring price movements and profit/loss, pips also play an important role in risk management. For example, a trader can identify a stop loss for a trade in terms of pips. This will limit the potential losses of the trade.
Pips also allow traders to calculate the most appropriate position size for a trade. This helps the trader ensure that he is not taking excessive risks by trading positions that are too large. Therefore, having a good understanding of pips is essential in order to improve their trading skills.
