Understanding Forex Pips
The world of forex trading is rife with numerous terms and terminologies that could be quite overwhelming for beginners. One such term that is crucial to understanding the mechanics of forex trading is ‘pips.’ In this article, we will provide look at what forex pips are, how they work, and how they influence our trading decisions.
Understanding Forex Pips
Pip is a unit of measurement used to express the change in value between two currencies in a currency pair. In forex trading, a pip is essentially the smallest price move that a given exchange rate can make based on market convention.
Most currency pairs on the forex market are priced to four decimal places, and one pip is then equivalent to a change of 0.0001. For such currency pair, one pip is one-hundredth of one percent (1/100 x .01).
For example, if the EUR/USD pair moves from 1.1150 to 1.1151, that .0001 USD rise in value is ONE pip. Consequently, a trader makes a profit or loss based on the number of pips that the currency price has moved, multiplied by the number of units of currency that the trader owns.
Why are Pips Important?
Pips serve as a standardized method of measuring how much an exchange rate has changed. This is crucial in the volatile world of forex trading, where the prices of currency pairs are moving rapidly. Pips help traders calculate the net profits or losses in their trades, enabling them to make informed trading decisions.
Moreover, pips are essential in managing risks. By determining the number of pips on your stop loss order and the average pip movement in a market, you can define an appropriate level of risk for your trading. Among other things, traders use pips to set their stop loss and take profit levels. A stop loss order is a defensive mechanism that allows traders to limit their potential losses, while a take profit order allows traders to secure their profits when the price reaches a predetermined level.
Forex Pips and Trading
Typically, forex traders use pips to calculate their potential profits or losses on a trade to make quick decisions. For instance, if a trader anticipates that the EUR will strenghten against the USD, they can decide to go long in EUR. If their prediction is correct and the EUR strenghtens against the USD by, say, 30 pips, they could make a substantial profit. Conversely, if the EUR falls in value against the USD by 30 pips, the trader would make a loss.
Spreads
On a forex trading platform, the bid-ask spread of a forex quote is typically measured in pips. Not understanding how pips work will make it difficult for a trader to correctly understand bid-ask spreads and how they will impact their trading.
Beware of the Japanese yen (JPY)
As mentioned above, most currency pairs on the forex market are priced to four decimal places, and one pip is then equivalent to a change of 0.0001. In JPY denominated currency pairs, however, one pip is only two decimal places, i.e. 0.01.
This is because of the JPY´s relatively low value against other major currencies, such as USD, EUR, and GBP.
The JPY is one of the most traded currencies in the world, so understanding how pips work for the JPY is necessary for many forex traders. The USD/JPY is the second-most traded currency exchange pair in the world, surpassed only by the EUR/USD.
Example:
In the case of USD/JPY, a single pip corresponds to one hundredth of a yen.
A trader believes the JPY is about to strenghten against the USD, and therefore sells USD/JPY at 114.08. Later, the position is closed at 114.03 and the trader profits by 5 pips.
This might look like miniscule movements, and they are, but they signify huge profits (or huge losses) for traders that open and close big positions.
If the position in the example above was a $10 million position, the profit was $10 million x (114.08 -114.03). 10 million x 0.05 = 500,000. (¥500,000 profit)
Conclusion
Understanding forex pips is crucial for anyone participating in forex trading. They play a pivotal role in determining profits and losses, and assist in risk management. As a trader, knowing how to calculate and use pips can help you make informed decisions, enhance your trading strategy, and ultimately increase your chances of success in the forex market. Therefore, take time to understand pips, their importance, and their application in trading, as they are a fundamental aspect of forex trading.