What is a Pip or Pips in Forex Trading

What is a Pip

“Pip” is a term derived from the abbreviation for “percentage in point” or “price interest point.” It signifies the tiniest possible price shift in the world of forex trading. Imagine you’re on a trading floor, and you witness the exchange rate of a currency pair making a subtle move. That minuscule shift is what we refer to as a “pip.”

In the forex market, most currency pairs are quoted with precision up to four decimal places. Consequently, a single pip corresponds to the fourth decimal place of the exchange rate, or 1/10,000th of the rate’s total value. To make this more tangible, let’s consider the USD/CAD currency pair. The smallest conceivable movement it can undergo is equivalent to $0.0001, which is just one pip.

Let’s explore a practical example: Suppose you are trading the EUR/USD currency pair, and its exchange rate changes from 1.1235 to 1.1236. This seemingly small shift of 0.0001 is indeed a single pip.

However, it’s important not to confuse pips with “bps” (basis points) utilized in the interest rate markets. Basis points represent 1/100th of 1%, which is equivalent to 0.01%. So, if you’re dealing with interest rates, and you observe an increase of 10 basis points, it signifies a 0.10% change, which is considerably more substantial compared to the subtle movements denoted by pips in the forex market.

How Pips work

In the forex market, traders engage in the buying and selling of currencies, each of which is valued relative to another currency. This valuation is reflected in forex pairs, with quotes that manifest as bid and ask spreads, providing a high level of precision, typically extending to four decimal places.

To gauge and quantify changes in exchange rates, the concept of “pips” comes into play. Given that the majority of currency pairs are quoted with up to four decimal places, the smallest possible unit of price movement for these pairs is precisely one pip.

Let’s delve into a practical scenario to illustrate this: When observing the exchange rate of a currency pair, such as EUR/USD, a shift from 1.1235 to 1.1236 denotes a movement of just one pip.

How to Calculate Pips

The value of a pip in forex trading is a variable that hinges on several factors, including the specific currency pair, the prevailing exchange rate, and the size of your trade. Let’s break this down further.

1. When USD is the Quote Currency (Second in the Pair): In this scenario, like in the popular EUR/USD pair, where the U.S. dollar (USD) is the second currency, the pip value remains constant at 0.0001. To compute the value of one pip, you simply multiply the trade value (also known as lot size) by 0.0001. For instance, if you’re trading 10,000 euros in the EUR/USD pair, the calculation would look like this: 10,000 euros × 0.0001 = $1. This means that a price movement of 10 pips, from 1.0801 to 1.0811, would translate into a $10 profit.
2. When USD is the Base Currency (First in the Pair): In contrast, if the U.S. dollar (USD) is the first currency, as in the USD/CAD pair, calculating the pip value becomes more intricate. Here, the pip value is determined by dividing 0.0001 by the current exchange rate and then multiplying this result by the trade size. For example, if the USD/CAD exchange rate is 1.2829 and you’re trading a standard lot size of 100,000, the calculation unfolds as follows: (0.0001 ÷ 1.2829) × 100,000 = $7.79. Consequently, a minor price shift of just 1 pip, from 1.2829 to 1.2830, would yield a profit of $7.79 in this case.

The JPY Pairs Exception

Japanese yen (JPY) pairs in the forex market present an interesting departure from the conventional four decimal place precision. Instead, they are quoted with just 2 decimal places, making them unique in this regard. Let’s delve into how the value of a pip is determined for JPY pairs, such as EUR/JPY and USD/JPY.

For JPY pairs, like EUR/JPY or USD/JPY, the pip value is calculated slightly differently. It is equal to 1/100 divided by the current exchange rate. For example, if the EUR/JPY pair is quoted at 132.62, the pip value would be:

1/100 ÷ 132.62 = 0.0000754

Now, let’s put this into perspective with a practical example. If you are trading a lot size of 100,000 euros in the EUR/JPY pair, the value of one pip, when expressed in USD, would amount to $7.54. This means that a minor price fluctuation of one pip, from 132.62 to 132.63, would result in a profit or loss of $7.54 when trading a 100,000 euro lot in EUR/JPY.