Many new traders start out with automatic forex trading using a forex robot, without understanding very much about what they are doing. Not surprisingly, this can often lead to problems. You do need to know a little bit about the terminology and structure of the forex market before you let your forex robot loose with any real money.
In this article we will look at pips: what they are and why we use them.
First you should know that ‘pip’ simply stands for Percentage In Point. Pips are sometimes called points and you may find it easier if you think of them that way.
Pips are used to measure changes in the price of a currency pair. So you might see a report that EUR/USD fell by 10 pips this morning. Why don’t they say it in dollars and cents? The reason is that not all forex trades involve the dollar, and even where they do, it may not be the quote currency. If your pair was EUR/JPY, you would not want to measure changes in dollars and cents. At the same time, it is clearly going to be confusing to have changes in each currency pair expressed in the different quote currencies. Therefore we use pips.
One pip is the smallest increment of the quote currency in any pair. In most cases, this means 0.0001 units of the quote currency. The quote currency is the second one in the pair as it is normally written, so in the case of EUR/USD the quote currency is the dollar. This pair is usually quoted to four decimal places, e.g. 1.3875. If it falls to 1.3874, it has fallen one pip.
In the case of EUR/USD and other pairs with USD as the quote currency, one pip is $0.0001 or 0.01 of a cent. Doesn’t sound much, right? But because of the high leverage that you can use in automatic forex trading, with a mini account you are likely to be dealing with lots of $10,000. Then one pip is $10 and a 10 pip movement in the right direction would give you $100 profit (without taking account of spread or broker costs). Not bad when your total funds might only be a couple of thousand dollars.
To calculate the value of a pip in dollars when the dollar is the base currency, for example USD/CAD, you will need to do one more calculation, which is 0.0001 divided by the exchange rate. Say the exchange rate was 1.1180. 1 pip would be 0.0001 Canadian, divided by 1.1180 gives 0.0000894. So in this case 1 pip would be 0.00894 of a US cent.
You should also note that the situation is a little different when the Japanese yen is the quote currency. One yen is worth a lot less than one US dollar, closer to the value of one cent, so for the sake of cross currency comparison, yen pairs are usually quoted to only 2 decimal places. This means that for a pair like USD/JPY, 1 pip is 0.01 yen. Divide by an exchange rate which might be around 100 and again one pip is worth approximately $0.0001.
These calculations will normally be done automatically for you in your broker account, so that you can always see the value of your balance and your open trades in US dollars or whatever currency your account is held in. However it can be useful to understand how the calculations are done. Sometimes you might want to work out ‘what if’ situations instead of relying on automatic forex trading, and then you can set up the formula for yourself in a spreadsheet.
The Forex Dude