February 10, 2017
In this article, we will discuss the relationship between pips and profits. A pip is the basic unit which measures the fluctuation of currency quotes. This basic unit is often referred to as one basis point which is usually equivalent to 0.0001. It’s the fourth decimal of a currency quote. A simple example will make the concept of pip crystal clear to you.
Let’s say the EUR/USD pair is trading at 1.0955. After one hour, the price has changed and is now equal to 1.0985. The EUR/USD pair just rose 30 pips, from 1.0955 to 1.0985.
However, in brokers that use 5-digit pricing quotes on their platform, the last digit is called a pipette and it is often referred as the fractional value of the pip, but where exactly did pips come from?
A percentage in point, or pip, is the unit of change of a currency pair in the forex market. Under the Bretton Woods system, established after World War II with the aim to govern monetary policies among countries, all currencies were pegged to the U.S. dollar and gold. As there was no volatility in exchange rates, some currencies didn’t even use pips, (i.e. the fourth decimal to quote against the U.S. dollar).
For example, the Japanese yen was pegged at a rate of exactly 270 yen per dollar in 1948, and 360 in 1949. The German Mark was pegged at 4.20 Marks per dollar in 1949, and revalued to exactly 4 Marks per dollar in 1961.
It is with the fall of the Bretton Woods system in 1971-73, that the newly unpegged currencies started to quote in much greater precision, making the concept of pips important. Today, currencies can even be quoted in pipettes, the fifth decimal in the exchange rate. Pipettes are even more precise than pips, as 10 pipettes equal one pip.
Lot Size vs. Pips
The number of pips a trader can make is the amount of money he can expect from trading. But the value of a pip also depends on your position size.For instance, if you trade with 1 standard lot (100,000 units) then one pip will be around $10, while trading a mini lot (10,000 units) will make a pip worth around $1. How the value of a pip is calculated is presented in the next article.
The Value of a Pip: Trading Different Lot Sizes
The lot size represents the size of your position in the market. Your profit factor in forex is directly related to your lot size since the value of each pip will depend on it. There are 4 major lot sizes in retail forex trading. If you buy 1 standard lot of EUR/USD then you are actually buying 100,000 euros in the market. Let’s see how different lot sizes affect the pip value in forex trading. The following table gives an overview of the difference in pip values for different position sizes.
Let’s say the EUR/USD pair is trading at 1.1235. So, if you open a trade with 1 standard lot, then your pip value will be calculated the following way:
- EURUSD 1.1235 = (0.0001 / 1.1235) X 100,000 units =8.9 USD or 9 USD per pip
- USD/JPY at 110.45: (.01 / 110.45) x 100,000 ) = $9.05 per pip
As you can see, the formulas are slightly different depending if the U.S. dollar is the base currency or the counter currency. With currency pairs like the USD/JPY, we also use .01 instead of .0001 to account for the difference in the decimal place of the pip.
But when you trade with a mini lot (10,000 units) then your new pip value will be calculated as:
- EUR/USD 1.1235 = (0.0001 / 1.1235) X 10,000 units =0.9 USD or 0.9 USD per pip
Now, you know that with 1 standard lot your pip value is 9 USD, and for opening one standard lot you will need around 1.1235 x 100,000 (1 standard lot) = 112,350 USD.
Pretty high, right! This is where leverage comes into action. In order to open 1 standard lot, you will require only $1,123 with a 100:1 leverage. With leverage, you can open a much larger position than your initial trading account size. If you have deposited 2000 USD, with a 100:1 leverage you actually have 2000 USD x 100 Leverage = 200,000 USD available to trade. Still, opening such a large position would take all of your account as margin, and the associated risk would be huge.
Though high-leverage trading account provides an extreme level of profit potential, traders should know that it might act as a double-edged sword. You should always follow proper risk management and never risk more than 2% of your account capital in a single trade.
Test Your Knowledge: Pips and Profits
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Pips and Profits: How do They Work Together
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