Posted on: 22 Jan, 2019
A pip in the forex market refers to the unit of measure to express a change in a currency pair. A pip stands for point in percentage and while it can be analyzed from an underlying currency standpoint, it’s often used as a measure of the quote in the currency pair. Understand the pip value of your positions is absolutely essential to control your risk.
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A pip in the forex market refers to the unit of measure to express a change in a currency pair.
A PIP stands for 'Point In Percentage' and while it can be analyzed from an underlying currency standpoint, it’s often used as a measure of the quote in the currency pair. Understanding the pip value of your open positions is absolutely essential to keep your risk under control.
The Difference Between Pip & Pipette
The quotes in forex currency pairs used to be comprised of 4 digits. As an example, if the EUR/USD exchange was rated at 1.3450, a variation in the quote to 1.3451, that 0.0001 difference, is what we would refer and still do as 1 pip.
However, in order to protect the retail trader, nowadays the quote of a currency pair tends to include 5 digits, so the same quote of 1.34500 in the past is now displayed as 1.34500. Therefore, a change from 1.34500 to 1.34501, that 0.00001 quote change, is what we refer as a pipette.
By adding an extra digit, it helps to standardize the size of an entry while protecting traders and investors from taking too large bets. The smallest change in a currency pair by a broker only quoting 4 digits can only be 1 pip while a broker offering 5 digits, as Global Prime does, then a pipette can also be accounted for as an option.
That same 1 pip change when 4 digits are applied would now be 1/10 pips (1 pipette) with the introduction of the 5 digits format, making the pipette option the smallest measure of change in a currency pair, even if the industry standards still use 1 pip as the universal measure to express changes in currency pairs.
The Importance Of The Pip Value
So, how will one pip change in the quote of a currency pair we’ve bought or sold affect our trading account?
The answers lie in three factors: The currency traded, the transaction size, and the current exchange rate.
Remember, we understand by 1 standard size lot a transaction of 100,000 units. We then have mini lots, which refer to 10,000 units, micro allows for transactions of 1,000 units, and nano being the smallest quantity one can transact worth 100 units. The pips value, as I will demonstrate below, is dependable on the three factors mentioned above.
Let me give you an example. If you as a retail trader buy 10,000 units of the EUR/USD pair at 1.34500 with a USD-denominated account, you will pay in exchange 1.34500 x 10,000 units = USD 13,450. If the price then changes by 1 pip, the pip value on a lot of 10,000 euro units would be USD 1 (1.34510 x 0.0001 - 1.34500 x 0.0001). If instead of 10,000 units, you purchased 1,000,000 units of euros or 10 standard lots, the value of 1 pip change = USD 100 (USD 1 x 100).
How To Determine The Pip Value In Your Account Currency
Since the forex market is a global endeavor with participants from all over the world, it’s important that you work out the pip value of your position in terms of your account currency as not everyone will have its account in USD. You could have your account denominated in AUD, CHF, SGD, etc.
What this means is that we must perform a very simple calculation to understand what that pip value will be based on your currency-denominated account. In a nutshell, you must simply multiply or divide the initial pip value by the exchange rate of your account currency and the currency you have transacted by buying or selling.
As an example, if instead of a USD-denominated account, you own a EUR-denominated account, the pip value would be as follows. A 1 pip change from 1.34500 to 1.34510 in EUR/USD on a 10,000 euro units would equal to EUR 0.7435 (USD 1 x 1/1.34510) in value to your trading account, or EUR 7.43 if trading 1 standard lot of 100,000 units.
When it comes to the Yen pairs, due to the JPY lower underlying value as a currency unit, with USD 1 at a rate of more than 100.00 yen, the industry standards is to only use 3 digits. That’s why you should not be surprised if the quote in the USD/JPY currency pair displays 110.102, that’s how the majority of brokers will display Yen-related quotes.
Leverage: A Double-Edged Sword
Back to the example above, if you wonder how an investor with a USD 10,000 account can control 10,000 units of euros at a EUR/USD exchange rate of 1.34500, which should cost the traders USD 13,450, well, welcome to the world of leverage.
Leverage is a double-edged sword. If used correctly with a high degree of caution and proper understanding of the inherited risks that it carries, you should perceive the ability to make use of leveraged accounts as a benefit to control larger lots.
For the experienced traders, it serves the purpose of exploiting one’s strategy to maximize returns without the need to put down as deposit the total amount transacted. You should see leverage as the brokerage lending you money with the trader or investor only in need to put down a relatively smaller ‘good faith’ deposit.
However, and that’s where the risk lies, you must understand that the more units of a particular currency that you buy or sell, the more your account will be hit by the change of every pip against you. By the same token, it can also increase your gains, but it must really be emphasized that what matters in forex is to limit the downside risks.
So, following the example above, if you choose to trade with a leverage of 100:1, what it means is that the broker will only require a deposit of USD 13,450 x 1% = USD 134,5. That’s how a USD 10,000 account can control much larger sizes.
Just don't ever forget, if your account goes through a severe drawdown and the capital in your account is not enough to cover the losses currently incurred due to excessive lot sizes traded, you run the risk of getting a margin call. A margin call will occur when the account value is not sufficient to meet the broker's minimum value required.
When a margin call happens, the broker’s internal risk mitigation system will kick in, in what is known as a ‘margin call’ event, whereby all positions will be automatically closed. Trading will no longer be allowed until the trader deposits additional funds so that the margin account is brought up to the minimum maintenance margin.
Before you start trading, you should have an impeccable grasp of how much you are risking in each and every trade. It all starts by coming to terms about the pips at risk but most importantly, the value of 1 pip change. Practice in a demo account first to get acclimated with the proper inner works of the trade sizes you are putting on and the pip value. Only when you are fully in control and comfortable, you can consider the next steps in your trading journey.
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