What is a Pip in Forex?
Pip is an abbreviation for ‘Point in Price’. It is a unit of value of currency, a very small amount, 0.0001 is one pip. One pip is equal to 1/100 of a Cent. It is required for all forex traders to calculate profit and loss. Using pips and lots profit and loss calculations can be done before, during or after a trade has taken place.
The unit of measurement to express the change in value between two currencies is called a pip. If EUR/USD moves from 1.2250 to 1.2251, that .0001 USD rise in value is 1 pip. A pip is usually the second to last decimal place of a quotation. Most pairs go out to 5 decimal places, but there are some exceptions like Japanese Yen pairs they go out to three decimal places. Brokers quote currency pairs beyond the standard “4 and 2” decimal places to “5 and 3” decimal places. They are quoting fractional pips, 1.51542 to 1.51543, that .00001 USD move higher is 1/10 of a pip.
What is a Lot in Forex?
In the past, spot forex was only traded in exact amounts called lots. The standard size for a lot is 100,000 units. There are also a mini, micro, and Nano lot sizes that are 10,000, 1,000, and 100 units respectively.
As you may already know, the change in currency value relative to another is measured in pips, which is a small portion of a unit of currency’s value. To take advantage of this small change in value, you need to trade large amounts of a currency to see any significant profit or loss.
Let’s assume we will be using a 100,000-unit (standard) lot size. We will now recalculate some examples to see how it affects the pip value.
- EUR/USD at an exchange rate of 1.1930(.0001 / 1.1930) X 100,000 = 8.38 x 1.1930 = $9.99734 rounded up will be $10 per pip
- GBP/USD at an exchange rate or 1.8040(.0001 / 1.8040) x 100,000 = 5.54 x 1.8040 = 9.99416 rounded up will be $10 per pip.
- USD/JPY at an exchange rate of 119.80(.01 / 119.80) x 100,000 = $8.34 per pip
- USD/CHF at an exchange rate of 1.4555(.0001 / 1.4555) x 100,000 = $6.87 per pip
As the market moves, so will the pip value depending on what currency you are currently trading.
How to profit from being a forex trader?
In the forex market, you buy or sell currencies. Placing a trade in the foreign exchange market is simple, the way you trade forex is similar to other markets; like the stock market. If you have traded stocks (shares), you can trade forex. Forex trading is exchanging one currency for another to profit in the expectation that the price will change. The currency bought increases in value compared to the one sol, and vice versa. An exchange rate is the ratio of one currency compared to another currency. For example, the GBP/USD exchange rate displays how many U.S. dollars it costs for one British pound, or how many US dollars you need to buy one British pound.
How to Read a Forex Quote
Currencies are always quoted in pairs, such as GBP/USD or AUD/USD. The origin of why they are quoted in pairs is since in every foreign exchange transaction, you are simultaneously buying one currency and selling another. Here is an example of a foreign exchange rate for the British pound versus the U.S. dollar:
The first listed currency to the left of the slash (“/”) is known as the base currency (in this example, the British pound), while the second one on the right is called the counter or quote currency (in this example, the U.S. dollar). When buying, the exchange rate tells you how much you must pay in units of the quote currency to buy one unit of the base currency. In the example, above, you must pay 1.51258 U.S. dollars to buy 1 British pound. When selling, the exchange rate tells you how many units of the quote currency you get for selling one unit of the base currency. In the example, above, you will receive 1.51258 U.S. dollars when you sell 1 British pound.
The base currency is the “basis” for the buy or the sell. If you buy EUR/USD this simply means that you are buying the base currency and simultaneously selling the quote currency; buy EUR, sell USD. You would buy the pair if you believe the base currency will appreciate (gain value) relative to the quote currency. You would sell the pair if you think the base currency will depreciate (lose value) relative to the quote currency.
First consider whether to buy or sell. If you want to buy (which means buy the base currency and sell the quote currency), you want the base currency to rise in value and then you would sell it back at a higher price. Professional traders would call this going long or taking a long position; long equals buy.
If you want to sell (which means sell the base currency and buy the quote currency), you want the base currency to fall in value and then you would buy it back at a lower price. This is called going short or taking a short position; short = sell.
All forex prices are quotes with two prices: the bid and the ask, the bid is lower than the ask price. The bid is the price at which your broker is willing to buy the base currency in exchange for the quote currency. This means the bid is the best available price at which you (the trader) will sell to the market. The ask is the price at which your broker will sell the base currency in exchange for the quote currency. This means the ask price is the best available price at which you will buy from the market, ask is also known as the offer price.
The difference between the bid and the ask price is popularly known as the spread. On the EUR/USD quote above, the bid price is 1.34568 and the ask price is 1.34588. If you want to sell EUR, you click the Sell button and you will sell euros at 1.34568. If you want to buy EUR, you click the Buy button and you will buy euros at 1.34588.
When to Buy, or Sell a Currency Pair
In the following examples, we are going to use fundamental analysis to help us choose whether to buy or sell a specific currency pair.
The Euro is the base currency and thus the basis for the buy/sell. If we think that the U.S. economy will weaken, which is bad for the U.S. dollar, you would execute a buy EUR/USD order. By doing so, you have bought euros in the expectancy that they will rise versus the U.S. dollar.
If you believe that the U.S. economy is strong and the euro will weaken against the U.S. dollar you would execute a sell EUR/USD order. By doing so you have sold euros in the expectancy that they will fall versus the US dollar.
In this example, the U.S. dollar is the base currency and thus the basis for the buy/sell. If you think that the Japanese government is going to weaken the yen to help its export industry, you would execute a buy USD/JPY order. By doing so you have bought U.S dollars in the expectancy that they will rise versus the Japanese yen.
If you believe that Japanese investors are pulling money out of U.S. financial markets and converting all their U.S. dollars back to yen, and this will weaken the U.S. dollar, you would execute a sell USD/JPY order. By doing so you have sold U.S dollars in the expectation that they will depreciate against the Japanese yen.
In this example, the pound is the base currency and thus the basis for the buy/sell.
If you think the British economy will strengthen against the U.S. in terms of economic growth, you would execute a buy GBP/USD order. By doing so you have bought pounds in the expectation that they will rise versus the U.S. dollar.
If you believe the British’s economy is reducing while the United States’ economy remains strong, you would execute a sell GBP/USD order. By doing so you have sold pounds in the expectancy that they will depreciate against the U.S. dollar.
In the forex market, currencies come in lots of 1,000 units of currency (Micro), 10,000 units (Mini), or 100,000 units (Standard) depending on your broker and the type of account you have. Margin trading is the term used for trading with borrowed capital. This is how you’re able to take larger transactions, quickly and inexpensively, with a small amount of initial capital.
Signals in the market are indicating that the British pound will go up against the U.S. dollar.
You open a trade of size, one standard lot (100,000 units GBP/USD), buying with the British pound at 1% margin and wait for the exchange rate to climb. When you buy one lot (100,000 units) of GBP/USD at a price of 1.50000, you are buying 100,000 pounds, which is worth US$150,000 (100,000 units of GBP * 1.50000).
If the margin requirement was 1%, then US$1,500 would be set aside in your account to open the trade (US$150,000 * 1%). You now control 100,000 pounds with just US$1,500. When you decide to close a position, the 1% margin that you placed when opening the trade is returned to you and a calculation of your profits or losses is done and credited to your account.
Your predictions come true and you decide to sell. You close the position at 1.50600. Your profit from the trade is $600.
All open positions, known as trades incur a charge for being held overnight, once a position is held past your broker’s rollover time (usually 02:00 CAT), there is a daily rollover interest rate that a trader either pays or earns, depending on your margin cost and position in the market. If you do not want to earn or pay interest on your positions, make sure they are all closed before rollover time. Since every currency trade involves borrowing one currency to buy another, interest rollover charges are part of forex trading. Interest is paid on the currency that is borrowed, and earned on the one that is bought. If you are buying a currency with a higher interest rate than the one you are borrowing, then the net interest rate differential will be positive; example the USD/JPY. Equally, if the interest rate differential is negative then you incur a cost.
What is leverage?
Any size investor can trade much larger amounts of money using leverage. A forex trading broker is like a bank who loans you money to trade currencies. All the brokers will require from you is that you place a margin of the loan as a deposit, which is refundable when the trade is closed. This is how forex trading using leverage works. The amount of leverage you use will depend on your broker and what you feel comfortable with, usually 100:1 or 200:1. Based on the leverage used each trade taken will incur a margin per lot traded. Once you have deposited your money you will then be able to trade.
For example, if the allowed leverage is 100:1 (or 1% of position required), and you wanted to trade a position worth $100,000, but you only have $5,000 in your account. No problem as your broker would set aside $1,000 as down payment, or the margin, and let you borrow the rest. Any losses or gains will be deducted or added to the remaining cash balance in your account. The minimum security (margin) for each lot will vary from broker to broker. In the example above, the broker required a one percent margin. This means that for every $100,000 traded, the broker wants $1,000 as a deposit on the position.
How to calculate profit and loss?
So now that you know how to calculate pip value and leverage, let’s look at how you calculate your profit or loss.
For example if we buy U.S. dollars and Sell British pounds.
- The rate you are quoted is 1.4525 / 1.4530. Because you are buying U.S. dollars you will be working on the ask price of 1.4530, or the rate at which traders are prepared to sell.
- You buy 1 standard lot (100,000 units) at 1.4530.
- Two hours later, the price moves to 1.4550 and you decide to close your trade.
- The new quote for USD/GBP is 1.4550 / 1.4555. Since you’re closing your trade and you initially bought to enter the trade, you now sell to close the trade so you must take the bid price of 1.4550. The price traders are prepared to buy at.
- The difference between 1.4530 and 1.4550 is 0.00020 or 20 pips.
- Using our formula from before, we now have (.0001/1.4550) x 100,000 = $6.87 per pip x 20 pips = $137.40