Pip is the smallest unit of measurement used in determining exchange rates between currencies.
What is pip?
In Forex trading, we monitor the changes of the rate between two currencies, in pips, which are the smallest change in the currency price, and that could be in the second, fourth, or, even fifth, decimal place of the price, depending on the currency pair.
Thus, a pip is the last decimal place of a quotation.
Half-pips are a more recent development offering to traders even tighter spreads and more competitive and transparent accuracy in pricing.
These price changes, expressed in the second up to the fifth decimal point, really, represent just fractions of a cent.
For example, when a currency pair like the GBP/USD, moves 100 pips, from 1.6500 to 1.6600, it just moves only $0.01 of the exchange rate.
This is why currency transactions must be carried out in big amounts, allowing these minute price movements to be translated into decent profits when magnified through the use of leverage.
When you deal with a large amount like $100.000, small changes in the price of the currency can result in significant profits or, possibly, losses.
When trading foreign exchange, the pip and its value will measure our profit or loss.
Example of pip calculation
As each currency has its own value it is necessary to calculate the value of a pip for that particular currency in a particular currency pair.
We also need a currency to be used as “point of reference”, so we will accept that we convert everything to US Dollars.
In currencies where the US Dollar is quoted as a Base currency (first), the calculation would be as follows:
USD/JPY: Example, JPY rate of 90.01 (notice that 1 JPY standard contract amounts to 100JPY therefore all the JPY pairs only go to two decimal places, most of the other currencies have four decimal places), 1 pip would be 0.01, so, to calculate the pip value in dollars (0.01 divided by the exchange rate = pip value) so, 0.01/90.01=0.000111
USD/CHF: Example, CHF rate of 1.0230, 1 pip would be 0.0001 (0.0001 divided by exchange rate = pip value) so 0.0001/1.0230 = 0.0000977
USD/CAD: Example CAD rate of 1.0647, 1 pip would be 0.0001 (0.0001 divided by exchange rate = pip value) so 0.0001/1.0647 = 0.0000939
In the case where the US Dollar is a quote currency (second) and we want to get back to the US Dollar value we have to add one more step – i.e. multiply it by the exchange rate of the account currency:
EUR/USD: (0.0001 divided by exchange rate (= pip value) and multiplied by exchange rate of account currency, so (0.0001/1.4950)*1.4950 = EUR 0.0001
GBP/USD: (0.0001 divided by exchange rate (= pip value) and multiplied by exchange rate of account currency so (0.0001/1.6340)*1.6340= USD 0.0001
It is obvious that the value of one pip depends on two variables; the amount of currency and the currency pair/exchange rate.
How to calculate pip value?
As mentioned earlier, when trading Forex, the pip and its value will measure our profit or loss.
The Forex is traditionally traded in lots also called contracts.
The standard size for a lot/contract is $100,000.
Nowadays Forex dealers offer to investors the possibility to trade decimals of one lot (0.1, 0.2, up to 0.9).
As we mentioned previously, currencies’ price changes are measured in pips, which is the smallest increment of that currency.
To take advantage of these tiny changes it is necessary to trade large amounts of a currency in order to obtain any substantial profit or loss.
In Forex, in order to trade amounts larger than the ones deposited in our account, we use leverage.
We shall cover leverage later but for the time being let’s assume that we will be trading $100,000 lot size.
We will now present some examples to see how the amount of a trade affects the pip value per contract.
In cases where the US Dollar is quoted first:
For USD/JPY at an exchange rate of 90.01 the value per pip is (0.01/90.01) X $100.000 = $11.11 per pip (rounded)
For USD/CHF at an exchange rate of 1.0230 the value per pip is (0.0001/1.0230) X $100.000 = $9.78 per pip (rounded)
In cases where the US Dollar is not quoted first you need to convert back to dollars using an additional calculation, i.e. multiplying by the exchange rate:
For EUR/USD at an exchange rate of 1.4950 the value per pip is (0.0001/1.4950)*EUR 100.000*1.4950 = USD 10.00 per pip
For GBP/USD at an exchange rate of 1.6340 the value per pip is (0.0001/1,6340)*GBP 100.000 * 1.6340 = $10 per pip.
We should remember that as the market moves so will the pip value depending on what currency you trade.
So now that investors know how to calculate the value of one pip per currency pair/contract size let’s examine at how you work out your P&L (profit or loss).