Forex trading is the exchange of one currency for another. This exchange is done in forex markets and it is important for international businesses as well as international trade. The exchange generally relies on a handful of currencies that belong to countries with liquid currencies or those with economic and political stability. Among the most actively traded currencies around the globe are the American dollar and the British Pound.
So, what is a Pip?
This is the tiniest amount by which a currency quote can change. A pip can be measured in terms of the underlying currency or the quote. This term refers to a price interest point or percentage in point, and it is a standardized unit which represents a small measure of the change in a currency pair in the forex market.
Traders often use the term pip to refer to losses or gains.
Currency pairs are mostly priced out to four decimal points, which means that this change is recorded in the fourth decimal point. This unit is equal to one hundredth of 1%. For instance, when the price of the USD/CAD pair moves from $1.4434 to $1.4435, it has moved by a single pip.
The term is normally followed by other terms like ticks, pipette and points, which may be a bit confusing. To help ease this confusion, we discuss them below.
So, what’s a pipette/point?
Apart from the standard 2 and 4 decimal places used to quote a currency pair, brokers can quote currency pairs using 3 and 5 decimal places.
They quote them using fractional pips, which are also known as pipettes.
Fractional pips are equal to one tenth of a pip, which allows brokers to view a currency pair like EUR/USD with pipettes to 5 decimal places. For instance, if EUR/USD shifts from 2.70546 to 2.70547, that 0.00001 move higher is equal to one pipette.
A fractional pip also allows brokers to view pairs with the Japanese yen as the counter currency to 3 decimal places. For example, in the GBP/JPY currency pair, a movement from 10.344 to 10.343 is a decrease of 1 pipette.
On the other hand, a point is a unit of measurement that’s used when a movement in the amount of the dollar is observed. For instance, if the price of a share increased to $20 from $15, brokers would say that it has shifted by 5 points.
This term is sometimes used as a substitute of pipette, to refer to movement of the fifth decimal place.
What’s a tick?
A tick is defined as the smallest increase a specific instrument can move in. While a tick is akin to a pip, it doesn’t measure every increase equally.
For instance, a tick of a certain instrument may be measured in increases of 0.25 while that of another could be measured in increases of 0.0001. This term is often used in indices or securities trading.
How is the value of a pip calculated?
The value of this unit of measurement is based off of the currency pairs that a trader is trading. This value is also dependent on which currency is the counter currency, and which one is the base currency.
A base currency, also known as the transaction currency, is the first currency which appears in the quotation of a currency pair. On the other hand, the counter currency, also known as the secondary or reference currency, is the second currency quoted in a currency pair. In most cases, major currencies are used as the base currency in a pair.
Given the example of EUR/USD, this means that one pip will be valued at USD $1 per 10,000 traded. Therefore, pip value is equal to the size of the pip multiplied by the base currency. You can learn more about the most traded currency pairs from the AccuIndex Academy.
It should be noted though that for currency pairs which involve the Japanese yen, a pip is equal to the change in the second decimal place. This is because the value of the yen is closer to one hundredth of the other currency and is a lower denomination. For example, in the GBP/JPY currency pair, a pip movement from 10.34 to 10.33 is a decrease of 1 pip.
Why should brokers calculate the pip value in their trading account’s currency?
Given that it’s the international market and not every trader has their trading account denominated in one currency, the pip value has to be translated into the currency an account is being traded in. For instance, if a trader’s account is based in GBP (Great British Pounds), they will have to convert that $1 into pounds.
This is done by diving the $1 by the currency GBP/USD exchange rate. It is important to divide because the pound is worth more than the US dollar, which means that the answer will be less than 1.
The amount you get will show how much you will lose or earn when trading. It is crucial that traders keep in mind that the currency they use to open their forex trading account will determine the pip value.
High-Risk Investment Warning: Trading foreign exchange on margin carries a high level of risk, and may not be suitable for all investors. The high degree of leverage can work against you as well as for you. Before deciding to trade foreign exchange you should carefully consider your investment objectives, level of experience, and risk appetite. The possibility exists that you could sustain a loss of some or all of your initial investment and therefore you should not invest money that you cannot afford to lose. You should be aware of all the risks associated with foreign exchange trading, and seek advice from an independent financial adviser if you have any doubts.