Understanding Forex Pips to Bolster Your Trading Strategy
What Looks like a Little Number Can Be a Big Deal in Trading
When trading in the foreign exchange market (Forex), it can be easy to overlook the value and importance of "pips."
More officially known as a percentage in point or a price interest point, a pip represents the smallest movement a currency pair can make on the market. This is typically equal to one basis point, but not always.
Pip Context Within Forex
Understanding what pips are and why they are relevant requires a mutual understanding of how Forex trading functions. Currencies must be exchanged to facilitate international trade and business. The foreign exchange market is where such transactions happen. For instances, if someone in the United States wants to make a purchase in Japan, their dollars must be converted to yen before that can happen. Forex enables such currency conversions and transactions to take place.
Pips are used to calculate the exchange rate in currency conversions when those transactions are made.
Value of Pips
The value of the pips for your trade can vary depending on your lot size when you're trading, and the difference in pips between the bid and ask is called the spread. The spread is basically how your broker makes money because most Forex brokers do not collect an official commission.
When your trade is positive in pips, you are making a profit. When it's negative, your trade is under water.
Some Forex brokers also allow trades to progress in fractional pips. Fractional pips allow for even tighter control on profits and losses and offer flexibility on spreads.
Changes in Pip Values
The base value of your account will determine the pip value of many currency pairs. If you open a USD-denominated account then currency pairs where the U.S. dollar is the second or quote currency, the pip value will always be $1 on a mini lot. You would only see changes in the pip value if the U.S. dollar changed significantly by more 10 percent up or down, and if the U.S. dollar is the base currency or is not involved in the pair, such as in EUR/GBP.
Here's an example: The value of USD/JPY fell from a ~120 to a low of 77.55 from 2008 through 2011. Because of the massive strengthening of the JPY, the pip value of the USD/JPY changed. Moves became more valuable per pip in U.S. dollars because the JPY had risen so aggressively against it.
These events are rare, but the point is that pip values typically are not fixed.
Relevance of Pip Values When Hedging
Many traders believe that they're in a risk-free position because they are hedged. Hedging is a risk-taking position because a widening spread eats into both positions. When an aggressive event occurs such as the Swiss National Bank de-pegging the CHF (the Swiss franc) to the EUR (euro), or the massive volatility seen in the aftermath of the EU Referendum that led to a Brexit, the difference between the bid and ask can widen by more than 100 pips in usually liquid pairs. If a trader is hedging a pair that's not liquid, the spread can be even more aggressive and result in a large loss to a hedged trader.