What is a ‘Pip’
A pip is the smallest price move that a given exchange rate makes based on market convention. Since most major currency pairs are priced to four decimal places, the smallest change is that of the last decimal point; for most pairs, this is the equivalent of 1/100 of 1%, or one basis point. For example, the smallest move that the USD/CAD currency pair can make is $0.0001, or one basis point.
Pip is an acronym for percentage in point.
BREAKING DOWN ‘Pip’
A pip is a basic concept of foreign exchange (forex) trading. When foreign exchange quotes are made or when traders transact in foreign currency, currency pairs are used. In simpler terms, forex traders buy or sell a currency whose value is expressed in relationship to another currency. For example, a trader that wants to buy USDCAD pair would be purchasing US dollars and simultaneously, selling Canadian dollars. On the other hand, a trader that wants to sell US dollars would sell the USDCAD pair, which means he would also be buying Canadian dollars at the same time. Traders often use the term “pips” to refer to the spread between the bid and ask prices of the currency pair and to indicate how much gain or loss was made from a trade.
In currency markets, each currency pair has a bid price and an ask price. The bid price is the price that a trader can sell a currency for, and is always lower than the ask price, which is the price that traders can buy a currency at. For example, if the USDCAD bid price is 1.2860 and the ask price is 1.2864, this means that a trader can buy 1 US dollar at the offer price of 1.2864 Canadian dollars. A trader looking to sell can do so at the bid price of 1.2860 Canadian dollars per US dollar.
The difference between the bid and ask price is referred to as the spread. The spread is usually quoted in pips, and in the example above, the spread for the USDCAD is 1.2864 – 1.2860 = 0.0004, or 4 pips.
Calculating a Pip
The movement in the exchange rate is measured by pips. Since most currencies are quoted to a maximum of 4 decimal places, the smallest change for these currencies is 1 pip. The value of a pip can be calculated by dividing 1/10,000 or 0.0001 by the exchange rate. The exception to this format is the JPY pairs which are quoted with 2 decimal places. For currency pairs such as the EURJPY and USDJPY, the value of a pip is 1/100 divided by the exchange rate.
For example, if the given quote for EURUSD is 1.1835, one pip for the currency pair is worth 1/10,000 ÷ 1.1835 = 0.0000845. If the EURJPY is quoted as 132.62, one pip for the currency pair is 1/100 ÷ 132.62 = 0.0000754.
A pip varies depending on how a given currency pair is traded; it is also possible but rare to price in half-pip increments. The value of one pip can have sharply different values depending on the currency pair and pricing convention.
Forex Gains and Losses
The movement of a currency pair determines whether a trader made a profit or loss from his or her trade at the end of the day. A trader who buys, say the EURUSD, will profit if euros increase in value relative to the US dollar. If the trader bought euros for $1.1835 per euro and exited the trade at EURUSD 1.1901, the trader would make 1.1901 – 1.1835 = 66 pips on the trade.
Now, let’s consider a trader who wants to buy the JPY. He does this by selling the USDJPY so that when the left pair decreases in value, he makes a profit, but when it goes up he makes a loss. The USDJPY is 112.06. If the price moves up to 112.09 when the position was closed, the trader will lose 3 pips on the trade. But if the trader closed at 112.01, he would profit by 5 pips. While the difference may look small, in the multi-trillion per day foreign exchange market, this quickly turns into a large number.
For example, if a $10 million trade was made on the USDJPY transaction which was closed at 112.01, the trader’s profit amount will be $10 million x (112.06 – 112.01) = ¥500,000. His profit in US dollars can be calculated as ¥500,000/112.01 = $4,463.89.
A combination of hyperinflation and devaluation can push exchange rates to the point where they become unmanageable. In addition to impacting consumers who are forced to carry large amounts of cash, this can make trading unmanageable, and the concept of a pip loses meaning. The best known historical example of this took place in Germany’s Weimar Republic, when the exchange rate collapsed from its pre-World War I level of 4.2 marks per dollar to 4.2 trillion marks per dollar in November 1923.
Another case in point is the Turkish lira, which had reached a level of 1.6 million per dollar in 2001, which many trading systems could not accommodate. The government eliminated six zeros from the exchange rate and renamed it the new Turkish lira, abbreviated YTL; its 2015 average exchange rate was a much more reasonable 2.9234 lira per dollar. A one pip move from 2.9234 to 2.9235 on $1 million is a difference of $34.20 as of 2016.