Pip is a commonly used acronym in forex that stands for "Price interest Point." It's the measurement of the price change of a currency pair expressed in decimal points, and it's the smallest tradable quantity quoted in the market by traders and brokers. You may also see it referred to as the following: Percentage in Points, points in percentage, ticks, basis points or, simply, points.
For investors interested in trading currencies, understanding the notion of a "pip" is an important element in analysing currency and market movements in addition to determining the overall cost and profit that can be generated by a trade.
In exchange rates expressed to two decimal places, a pip would be equal to a change of 0.01, whereas in rates expressed to four decimal places, a pip would be equal to a change of 0.0001. For most currencies, a pip can be considered as one unit of the fourth decimal point. In the case of the yen, which is an exception, it is one unit of the second decimal point.((Retrieved 23 October 2015 http://www.ftse.com/products/downloads/Real_Time_Currency_Valuation_in_the_Global_FX_Marketplace_Curex_white_paper_September.pdf))
How Is A Pip Used?
We know that physical goods, such as clothing or groceries, can be purchased with money in simple decimal notation. Dollars, for example, are divided into cents, and most currencies can be divided into increments of one-hundredths, or the equivalent of 0.01. But in currency trading, the item purchased is another currency. Further, currencies are often traded globally in large volumes.
According to data from the Bank for International Settlements, nearly US$5 trillion in currencies can be traded on the global market on any given day. In this environment, even small price movements can translate into large volumes of money changing hands if a transaction is of a large size. For this reason, it is convenient to trade currencies in smaller increments of one ten-thousandth, or 0.0001.
The four decimal point convention for quoting currencies is helpful, because it means that for a standard lot of currency, sold in batches of 100,000 units, the price change of 1 pip will be equivalent to 10 units of a currency. For a mini lot, traded in 10,000 units, the price change of 1 pip will be equivalent to 1 unit of a currency.
Handle And Dealing Price
Price quotes on most currency trading platforms are composed of what is known as the "big figure," or "handle," and the "dealing price," which is understood to move in pips. For example: in the quote 1.0485, the first portion of the quote, 1.04, is understood to be the "handle," and the last two digits of the quote, 85, are the dealing price in pips. The handle, or big figure, changes only when there is greater movement in currency prices, while the dealing price in pips customarily changes frequently in intraday trade.
Working With Pips
Currencies are traded in pairs. The first is known as the base currency, and the second is known as the counter currency, also referred to as the quote or target currency. When quoted in the market, the counter currency is expressed in its value per unit of the base currency. For example, when trading the U.S. dollar against the Swiss franc, the investor might see a quote of USD/CHF1.0481, meaning each dollar could be traded for 1.0481 Swiss Francs.
Depending on the exchange rate in effect, each pip can be considered to have a specific value quoted in the counter currency. This can then be multiplied by the dollar amount bought or sold to determine how much the price movement of each pip is worth.
Spread, Costs, Profit And Loss
Currency trading is normally done through brokers. To make money on dealing currencies, the brokers will sell you a currency at one price and buy it back from you at a lower price. Thus, in trading currencies, the currency pair is expressed at both an ask (or buy) price, and at a bid (or sell) price.
If the ask price is 1.0485, then the Swiss francs in the example above could each be bought from the broker for 1.0485 per dollar. Similarly, if the bid price is 1.0481, then the francs could be sold to the broker for 1.0481 per dollar. In this case, the pair would be quoted as USD/CHF 1.0481/85. The ask price will always be higher than the bid price, so that the broker will be guaranteed to cover their cost of doing business. The difference between the bid and ask price is called "the spread." In the case of the above example, the spread would be equal to 4 pips.
Although this size of spread is common, spreads can be much wider when the market is very volatile or when there is low volume being traded. In effect, while the spread, expressed in pips, it is the minimum amount that a currency broker will earn when a currency is sold and bought, it is also the minimum cost that a trader will pay when buying and selling a currency if there is no movement in its price.
In addition to determining costs, tracking the change of pips is important for traders in determining the potential profit, or loss, that might be made on a trade. As exchange rates vary throughout trading, traders can make or lose money depending on whether the bid and ask prices change enough, and in the right direction, to offset any costs imposed by the spread.
For example, if the bid/ask spread moves from 1.0481/85 to 1.0491/95, the trader can buy the currency at 1.0485 and sell at 1.0491, making a profit equivalent to the value of six pips. However, if the bid/ask spread moves from 1.0481/85 to 1.0483/1.0487, the trader would buy the currency at 1.0485 and sell at 1.0483, taking a loss equivalent to the value of two pips. In the latter case, even though the exchange rate moved in the right direction, it didn't move enough to compensate for the cost imposed by the spread. Further, traders need to be aware that if the spread moves in a negative direction, for example, from 1.0481/85 to 1.0479/81, they will take a loss equivalent to the value of six pips.
To determine the monetary amount gained or lost on a trade, the investor will multiply the number of pips changed at the close of a trade by the dollar (or base currency) value of each pip.
For example, if a pip in a currency transaction is determined to be worth US$5 and the currency quote changed by 10 pips from 1.0475 to 1.0485, then the investor would have made a gain in the transaction of: US$5 x 10 pips price change = US$50. However, if the quote moves in the opposite direction, from 1.0485 to 1.0475, then the investor would be subject to a loss of US$50.
While it is customary for quotes of currencies to be made in four decimal places, in some cases of very large transactions quotes are made in up to 5 or 6 decimal places. Recent advances with electronic trading have allowed individual investors to trade in fractional pips, or pipettes, as they are sometimes referred to, which permit pricing at a tenth of a pip. The fractional pip is designed to allow traders to work with smaller price increments and moves in the market.
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