What Is A Forex Pip?
Forex pairs move in increments of pips – for every pip the pair moves in your favor, you make money, for every pip the pair moves against you, you lose money..
Usually the pip is the fourth decimal place in the quoted exchange rate, though if the pair is quoted in Japanese yen then a pip is the second decimal place.
For most of the major forex pairs quoted in US dollars, the value of a pip is USD10, and one contract is defined as 100,000 of the first named currency. If the AUD/USD exchange rate is 1.0664 US dollars to 1 Australian dollar this means that AUD100,000 can buy USD106,640, so we could represent the AUD/USD pair as AUD100,000/USD106,640. For every pip that the value of the Australian dollar goes up, you earn USD10 – so a one pip rise would look like AUD100,000/USD106,650.
If a different currency pair was quoted, the value of a pip would also be different, so for the EUR/GBP pair, a pip would be 10 pounds, rather than 10 dollars.
Let’s use a forex CFD as an example – when you trade a forex CFD you trade on a margin, meaning you only need to outlay a fraction of the total value of your position, so it’s a more realistic starting point for new traders who may not have the capital to buy actual currency.
If the AUD/USD bid/offer spread is quoted at 1.0664/1.0665*, you could choose to sell a number of contracts at 1.0664 in the hope that the currency would fall, in which case you would be able to make money on the difference in price when you buy back the currency at a later date, i.e.: going short. Or, you could choose to buy a number of contracts at 1.0665, with the hope that the value of the Australian dollar would go up, and then you could make a profit by selling your contracts at a higher price once the value has risen, i.e.: going long.
You think the Australian economy is looking good, so you decide to go long, buying five contracts at 1.0665. This makes the value of your position USD533,250 (5 contracts x AUD100,000 x USD1.0665 = USD533,250). To open the CFD position, you just need to supply a deposit of 0.5%, or USD2,666.25.
A few days later the AUD/USD has risen to 1.0701/1.0702 and you take your profit by selling your five contracts at 1.0701. Your profit is calculated by subtracting the value of your opening transaction from the value of your closing transaction.
Closing transaction 5 contracts x AUD100,000 x USD1.0701 = USD535,050
Opening transaction 5 contracts x AUD100,000 x USD1.0665 = USD533,250
Gross profit = USD1,800
Or, if you’d prefer to calculate the gross profit in pips, the difference between your closing and opening position is 36 pips (1.0701 – 1.0665 =.0036). A pip is worth USD10, so 36pips x USD 10 = USD360. As you had five contracts, USD360 x 5 = USD1,800.
*This is a bid/offer spread of 1 pip, or.0001. With a 1 pip spread, the value of the first-named currency only needs to change by 2 pips for you to make a profit. CFD and forex providers can have varying bid/offer spreads, and you will need more significant currency shifts to make a profit the wider these are. It is always a good idea to choose a forex and CFD provider who will pass tight spreads onto their clients when the spreads in the underlying forex market are narrow.
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