The Concept Of The Forex PIP

It might seem strange that quotes are given to four decimal places but the fourth decimal place is an important element of a quote as it represents the smallest amount by which one currency can move against another and is known as the PIP (or sometimes as the POINT).

In the quote we gave when looking at a simple forex quote for the USD/GBP of 0.5436/0.5441 the spread between the two quote figures is said to be 5 pips, which is a typical spread for the major trading currencies.

One important thing that we need to do at this stage is to learn how to calculate the value of a pip as this will help us to calculate our potential profit (or loss) as we watch the value of a currency which we are actively trading.

In most cases you will want to work in a common currency regardless of the actual currency pairs you are trading and so, for the purpose of this example, we'll assume that your own natural currency is the US dollar.

Calculating pip values can now be divided into two separate calculations - one in which the US dollar forms the base currency in any quote and one in which the US dollar is the quote currency. We'll start with the US dollar as the quote currency.

Before we can actually calculate the value of a pip we need to consider the size of the transaction. Unlike buying and selling currency at a bank or local money changer when you are on holiday, currency trades on the Forex market are normally conducted in fixed lot sizes and the standard Interbank lot size is 100,000. In other words if you wish to buy or sell a currency then you will normally do so in lot sizes of 100,000 dollars, pounds etc.

Note: If at this point you are wondering how on earth the private trader can ever afford to buy and sell in these quantities then the simple answer is that they don't and one of the beauties of forex trading is that the private trader can participate in the market with much smaller sums of money.

So, back to our trading lot. Lets return to our example from before of USD/GBP but turn the quote around so that the USD is the quote currency. In this case the quote might be:

GBP/USD = 1.8395

This quote means that 1 British Pound is worth 1.8395 dollars and that if you were to sell the dealer 100,000 British Pounds he would give you 183,950 US dollars.

Let's assume however that the rate moves by 1 pip and that the quote changes to:

GBP/USD = 1.8396

If you now sell the dealer 100,000 British Pounds he would give you 183,960 US dollars so that you make a profit on this 1 pip move of $10.

If you run this calculation with any currency pair you will always find that the value of 1 pip is $10 as long as the US dollar is the quote currency.

Simple so far? Okay now let's look at the US dollar as the base currency.

In this case each value of a pip will vary from one currency to the next and each pairing USD/GPB, USD/JPY etc. will need to be separately calculated.

Consider this quote:

USD/GBP = 0.5436

Here 100,000 US dollars are worth 54,360 British Pounds. If the quote moves by 1 pip to 0.5437 then 100,000 US dollars will now be worth 54,370 British Pounds so that the pip value will be 10 British Pounds. However, we need this value in US dollars so we now need to convert this back to US dollars at the current exchange rate of 0.5437 which is done simply by dividing our 10 British Pounds by the exchange rate of 0.5437 to give us a pip value of $18.39 (10 ÷ 0.5437).

The problem with calculating the pip value when the USD is the base currency is that not only will it vary from one currency pairing to the next, but it will also vary as the exchange rate moves. However, before you panic, you should know that with the electronic nature of trading today this calculation is normally done for you and you don't need to revert to your calculator and a pencil. All you have to do is rely on your forex trading strategy to do the work for you.

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Forex: GBP/USD within 25-pip range above 1.5900 - FXstreet.com
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