For beginners, forex trading may seem overwhelming. To grasp this seemingly complex concept, one must first familiarise oneself with numerous terms and nuances. Among these is the term ‘pip’.
But what exactly is a pip in forex trading? And how do you calculate its value? In this article, we’ll break down everything you need to know about pips in forex trading. So, let’s start from the basics!
What is a Pip?
A pip, short for ‘percentage in point’ or ‘price interest point’, is a unit of measurement used to track price movements in the foreign exchange market. It represents the smallest change in value of an exchange rate and is usually measured up to four decimal places. For example, if the EUR/USD currency pair moves from 1.05500 to 1.05550, that is a change of 5 pips.
Certain currency pairs like USD/JPY have a third decimal place, so the pip in this instance is measured up to two decimal places. This means that if the exchange rate changes from 109.500 to 109.550, that is also a change of 5 pips.
Forex traders often use the term ‘pip’ when referring to price changes or spreads of a currency pair. Let’s consider a EUR/USD trade scenario:
- Current market price of EUR/USD: 1.0550
- ‘Ask’ price (buy): 1.0552
- ‘Bid’ price (sell): 1.0548
In this case, there is a spread of 4 pips between the bid and ask price. This means that the price needs to move at least 4 pips in your favour before you can make a profit.
What is a Pipette?
A pipette, also known as a fractional pip or point, is the fifth decimal place in a currency pair’s exchange rate. It represents a tenth of a pip and is used when measuring very small price changes.
For example, if the EUR/USD exchange rate moves from 1.05500 to 1.05505, that is a change of 0.5 pips or 5 pipettes.
How to Calculate the Value of a Pip
The value of a pip is determined by the size of your trade and the currency pair you are trading. In general, the base currency, which is the first currency listed in a currency pair, will determine the pip value.
To calculate the value of a pip in your account’s currency, you can use the following formula:
Pip value = (0.0001 / Exchange rate) x Position size
Let’s use EUR/USD as an example again. If we have a position size of 100,000 units and the exchange rate is currently at 1.0550, the pip value would be calculated as follows:
(0.0001 / 1.0550) x 100,000 = $9.48 per pip
Keep in mind that this is the value of a single pip for a standard lot size of 100,000 units. If you are trading a different lot size, you will need to adjust your calculations accordingly. Some trading platforms also have pip calculators that can do this calculation for you.
How to Calculate Lot Size Based on Pip Value
Now that we understand how to calculate pip value, let’s see how we can use it to determine our lot size based on a given stop loss (SL) in pips. This will help us manage our risk and determine the appropriate position size for a trade.
The formula for this is:
Lot Size = Risk in $ / Pip Value per standard lot / SL size in pips
Let’s say we have a trading account with $10,000 and we are willing to risk 2% of our account on a trade. Our risk would be $200. If we are trading EUR/USD and our SL is set at 20 pips, the lot size would be calculated as follows:
$200 / $9.48 per pip / 20 pips = 1.05 standard lots
This is just one way to manage risk and determine lot size. There are other methods and strategies that traders use, but understanding the value of a pip is an important aspect of risk management in forex trading.
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