Pip or Percentage In Point is one of the first technical terms a beginner comes across while learning about the forex market. It is also referred to as Price Interest Point, and understanding the concept of pips is essential for any forex trader since it plays a key role in the trading process. In fact, it is the most basic piece of information you would need while navigating the forex market to make profits from the constant price fluctuations. Hence, anyone who is preparing to enter the forex world must spare enough time to learn about forex pips and their relevance.
I have made it easy for you with this comprehensive preparation guide, which will cover all the basics of pips in forex as well as their application in the actual trading process.
Basics and History of Pips
As mentioned in the introduction, pip is a technical term that stands for ‘Price interest point’ or ‘Percentage in point’ in forex. From this, you can guess that pips are related to prices but have something to do with percentages and points. The forex market is known for its frequent price movements, which also makes it a favourite spot for traders as they are presented with many trading opportunities daily. Keeping track of the exchange rate fluctuations was a complex process in the early days due to currency value differences. The monetary value of a price change will differ for each trader based on the home currency they have chosen for funding the trading account.
Thus, a universal and standardised method was needed to measure the currency price fluctuations and determine its monetary value in the trader’s account base currency. The concept of pips was introduced as a solution, and it became the forex unit to track the smallest price movements that can happen in a currency pair. In the initial phase, pips were only applied on a percentage basis. However, with technological advancements, the concept of fractional pips, designed to support decimal pricing, was introduced. The term ‘pipette’ is basically fractional pips, and it is 1/10th of a standard pip.
In the case of pairs that include Japanese Yen, 1 pip is equal to 0.01, and for all other pairs, it is 0.0001. The currency price movements that happen within a shorter time frame are mostly minor, which is why decimal places are used for stating and expressing these changes comprehensively. The price movements happening in a pair are always stated as the number of pips by which it has increased or decreased. It can be hard to determine the profits in pips, especially when you are trading multiple currency pairs.
To simplify things, traders use a profit calculator, which calculates the profits in their account’s base currency to give them a clearer picture of their actual profits. Let’s take the example of the USD/JPY pair to understand the calculation of pip movements. Suppose the pair’s current price is 145.30, and later it becomes 145.33. In this case, the pair has moved 3 pips.
Relevance of Pips in Forex Trading
Pips are not just relevant for forex traders, but it is inseparable from the trading process as you won’t be able to make any trading decisions without applying the concept of pips. Below, I have added some points that state the relevance of pips in simple terms.
- Precision in Trading: As forex markets are highly volatile and small price movements can translate into significant gains or losses, pips allow traders to assess these minute fluctuations with precision.
- Profit and Loss Calculation: Pips determine a trade’s potential profit or loss. The difference between the entry and exit prices in pips directly influences the monetary outcome of a trade.
- Risk Management: Traders use pips to calculate the risk/reward ratio of a trade. This helps in making informed decisions about position sizing and stop-loss placement to manage risk effectively.
- Trade Entry and Exit: Pips guide traders when to enter or exit trades. Depending on technical analysis or trading strategies, a specific number of pips might trigger a buy or sell order.
- Volatility Measurement: Pips are a tool for assessing the volatility of a currency pair. A higher pip movement within a short span of time indicates greater volatility, which can offer more trading opportunities but also carries higher risks.
- Spread Calculation: The difference between the bid and ask price, known as the spread, is often quoted in pips. A narrower spread can reduce trading costs for traders.
- Pip Value calculation: The value of a pip is not constant across all currency pairs, and its monetary value changes based on the base currency of your account. Traders must understand pip values to make accurate profit and loss estimations.
Applying pips in Buy Limit and Buy Stop
In forex trading, you get two primary order types: market order and pending order. Market orders are used to enter the market right away, as the order will be immediately executed at the current market price. But sometimes, you want to enter a trade only when the currency pair reaches a specific price. In this case, you can use a pending order where the order will not be executed unless and until it reaches your desired price. Buy Limit and Buy Stop orders are both pending orders, and the concept of pips must be applied to place such orders precisely.
When you expect a drop in the price of your chosen currency pair, which will be followed by a reversal leading to an uptrend, you can simply place a buy limit order instead of keeping your eyes glued to the screen for entering the trade at the best price. The buy limit order will be placed below the current market price, and that way, you can enter a trade automatically once the limit is reached. On the other hand, Buy Stop is used when you want to enter a trade only after confirming a steady uptrend. This type of order will be placed above the current market price so you can enter the trade once the price touches the desired level.
Now, to talk about the application of pips in buy limit and buy stop order, setting the buy limit or buy stop is easier when you know the distance or offset, which is the difference between the current market price and the Stop or Limit price that you are aiming for. For this, you need to have a good understanding of the number of pips and pip values.
Applying Pips in Other Forex Concepts and Calculations
In technical analysis, pips are integral to identifying support and resistance levels. Traders often consider historical price levels in terms of pips to anticipate potential price bounces or breakouts. This assists in making informed entry and exit decisions. Pip movements also factor into volatility assessment. Volatility is often measured using the Average True Range (ATR), which incorporates pips to gauge market fluctuations over a specified period. Understanding volatility aids traders in adapting their strategies to varying market conditions, and this empowers traders by providing relevant information that can be used to make better trading decisions.
Moreover, pips facilitate correlation analysis between currency pairs. Correlated price movements of pairs, whether positive, negative, or neutral, can be quantified using pips. This insight helps traders diversify their portfolios effectively, minimising risk exposure to interconnected currencies. In fact, risk management will be simply impossible without applying the concept of pips. But the calculation of pips can be a bit complex when you try to do it manually, especially when you trade with a bunch of different currency pairs. The pip value will be different for each currency pair, and knowing the actual value in your account base currency is also important for planning the trade well.
Beginners often have a hard time doing pip calculations on their own, and even experienced traders are prone to making mistakes due to the complexity. Hence, pip calculators have become an essential tool for each and every forex trader. Nowadays, most forex brokers and trading platforms have a pip calculator added to their traders’ toolkit, which is available for free usage, and all you need is an internet connection. A pip calculator is an algorithm-based tool that always gives accurate and instant results once you enter relevant details like account base currency, chosen currency pair, lot size and number of pips for which you want to calculate value.
Sum Up
The concept of pips in forex plays a key role in the trading process, from measuring the price movements to calculating potential profits/losses and managing the risk by default. In addition to this, pip calculations are also applied in volatility assessment, correlation analysis, and they also support technical analysis. Based on all these, pips can be referred to as the foundation of all forex trading activities as well as a key metric in making trading decisions.
