Once you first join the forex trading market, you will often hear of the term pip. What does it actually mean and how does it work?
Pip stands for percentage in point. It is the smallest move of price that a trade rate can make depending on foreign exchange market convention.
Most of the currency pairs are valued to four decimal places and pip move is the fourth or last point. Thus, a pip is equivalent to 1/100 of 1%.
How Does Pip Works?
A pip is a fundamental concept of forex. Foreign exchange pairs are used to distribute trade values through bids and ask values that are exactly four decimal places. Simply, forex traders sell or buy currencies whose values are expressed in connection to other currency.
Exchange rate movements are measured by pips. Since mainly of the currency pairs are values to four decimal places in a maximum, the smallest swap for these pairs is 1 pip. The price of a pipe can be computed by dividing 0.0001 or 1/10,000 by the trade rate.
For instance, a forex trader wants to buy USD/CAD currency pairs. He will be buying US dollars and at the same time selling Canadian dollars. On the other hand, a trader who wishes to sell USD will sell the USD/CAD currency pair, purchasing Canadian dollars simultaneously.
In forex trading, pip is usually used to refer to the spread between the ask prices and the bid of the currency pair and to specify the amount of profit or loss can be obtained from the trade.
JPY currency pairs are priced with two decimal places, indicating a notable exemption. For USD.JPY and EUR/JPY currency pairs, the price of a pip is the quotient of 1/100 and exchange rate. For instance, if the EUR/ JPY is priced as 145.23. one pip is 1/100 divided by 145.23, equals 0.00006886.
Pips and Profitability:
The currency pair movement defines whether a forex trader has profited or had losses from his position. A trader who purchases the EUR/USD will benefit if the value of euro increases relative to the US dollar.
If the forex trader acquired the euro for 1.1735 and exits the trade at 1.1800, that trader would make 1.1800 – 1.1735 = 65 pips on that trade.
Now, consider a trader who procured the JPY by selling USD/JPY at 112.06. the trader will lose 3 pips on that trade if closed at 112.09 but will gain by 5 pips if the place is closed at 112.01.
Example of Pip in Real World:
A combined devaluation and hyperinflation can push trade rates to the position where they become uncontrollable. Besides affecting the consumers who are obliged to carry huge amounts of money, this can make forex trading out of control and the idea of pip will lose its meaning.
The well-known example of this in the history happened in Weimar Republic in Germany, when the conversion rates subsided from the pre-World War I degree of 4.2 points per dollar to 4.2 trillion per dollar in November of 1923.