On the foreign exchange markets, currency trading frequently takes place between the Japanese yen, the United States dollar, the euro, and the British pound in addition to the Canadian dollar.
A “pip,” also known as a “percentage in point” or a “price interest point,” is a unit of measurement that refers to the most minute change in price that can be caused by any given exchange rate. The value of a currency pair is typically quoted to four decimal places, which means that the final digit will reflect even the most minute shifts in the value of either currency.
As a result, one pip would be equivalent to 1/100th of a percent, which is the same as one basis point. If, for instance, the price of the currency that we mentioned earlier moved from 1.1200 to 1.1205, this would represent a change of five pips.
The relationship between the euro and the U.S. dollar is typically represented by a currency pair. One example of such a pair is EUR/USD. The initial currency is referred to as the base currency, while the subsequent currency is known as the quote currency.
Therefore, if you wanted to buy EUR/USD at 1.1200 on a trade for 100,000 currency units, you would need to pay US$112,000 (100,000 times 1.12) for 100,000 euros. This brings the total amount of money you would need to pay to US$112,000.
To determine the value of one pip in a currency pair, an investor must first convert one pip to its decimal representation (i.e., 0.0001), then divide that number by the current exchange rate, and finally multiply the result by the notional amount of the trade.
There are four significant currency pairs that are among those that are traded the most and have the highest volume.
These are what are referred to as the major pair combinations. There are four pairs: EUR/USD, USD/JPY, GBP/USD, and USD/CHF.
The United States dollar is featured in each of these currency pairs. When dealing with currency pairs denominated in yen, a pip is equal to just two decimal places, or 0.01.
Many times, the trading of currencies takes place in lots that are equal to one thousand of the underlying currency.
Consider the example of the Euro to US Dollar currency pair to better understand how pips work in the context of currency pairs. Consider for a moment that the price of one pip is 8.93 euros ((0.0001/1.1200) multiplied by 100,000). To determine how much one pip is worth in United States dollars, simply multiply the value of one pip by the current exchange rate. This results in the value of one pip being equal to $10 (8.93 multiplied by 1.12).
Because of variations in the rates at which different currencies are traded against one another, the value of one pip is never the same from one currency pair to the next. When the United States dollar is used as the quote currency, a certain phenomenon does take place. When this is the case, the value of one pip, based on a notional amount of one hundred thousand units of currency, is always equal to ten dollars US.
The Connection Between Points of Increment and Profitability
The movement of a currency pair is what determines whether or not a trader makes a profit or loses money. A trader who purchases the EUR/USD currency pair stands to gain if the value of the euro rises in comparison to that of the US dollar. If the trader purchased the Euro at 1.1835 and then sold it at 1.1901, they would have made a profit of 1.1901 minus 1.1835, which is equal to 66 pips on the trade.
Now, let’s take a look at a trader who purchases Japanese yen by selling US dollars in exchange for Japanese yen at the rate of 112.06. If the trade is closed at 112.09, the trader will incur a loss of 3 pip, but if the position is closed at 112.01, the trader will realize a gain of 5 pip.
In a market that involves multiple trillions of dollars, even a seemingly insignificant difference can result in significant gains or losses very quickly. For instance, if a trader holds a position worth $10 million and closes it at 112.01, they will record a profit equal to $10 million multiplied by (112.06 - 112.01), which comes to $500,000. This profit is expressed in dollars as 500,000 divided by 112.01, which equals $4,463.89.
