5/15/11

Forex Pip Definition

A pip refers to the smallest increment of a given currency. In the FOREX, or foreign exchange market, pips are representative of the most minute fluctuations in the value of a currency. In the realm of FOREX trading, pips play an important functional and speculative role. A small change in a pip can heavily affect the value received when a currency is bought or sold.
  • FOREX

    • FOREX is a common nickname for foreign exchange and the global market for the purchase and sale of international currencies. Participants in this market trade currencies for both functional and speculative reasons. Currencies are priced against each other at exchange rates, which are ratios of the value of any two currencies being exchanged for one another. The term FOREX is frequently used in connection with Web-based currency trading, which is a growing, albeit risky practice among speculative investors.

    Exchange Rates

    • An exchange rate is the price of any currency with regard to another. Formed using any two currencies, or currency pair, exchange rates fluctuate on a constant basis as the supply of and demand for currency changes from moment to moment. To illustrate a common exchange rate, consider the U.S. dollar (USD) against the U.K. pound sterling (GBP). If 1 GBP is equal to 1.5 USD, the exchange rate would be expressed as 1.50 USD/GBP. Likewise, the cost of 1 USD in terms of GBP at this same rate would be 0.66 GBP/USD (the reciprocal of 1.5).

    Pips

    • The term "pip" means "percentage in point" and is, specifically, the lowest incremental level into which a currency may be denominated. The pip for the U.S. dollar, for instance, is the cent. In the FOREX market, the pips take on a greater significance. Exchange rate fluctuations, even if present only in a pip, can mean the difference between a healthy profit and a devastating loss where currency traders are concerned. Exchange rates are generally carried out to four pips, or four decimal places, with the exception of Japanese yen, the prices for which are expressed with two pips.

    Pips as Multipliers

    • Since currency trades typically comprise several thousand dollars' worth of currency, the effect of any movement, up or down, in the value of only a pip can result in tremendous gains or losses. This means that for every unit-movement up or down of a pip in the stronger currency, there is a proportional amount of money being gained or lost, depending on the size of the trade and the direction of the price change.

    Example

    • To illustrate, suppose the GBP-USD exchange rate is 1.5081 and someone wishes to invest 10,000 USD in GBP. The USD pip multiplier is obtained by calculating 0.0001 / 1.5081, or 0.0000663. This result is then multiplied by the 10,000 USD being traded: 0.0000663 x 10,000 USD = 0.663 USD. This means that for each change, up or down, of 0.0001 GBP, the investor gains or loses $0.66 should he exchange 10,000 USD for GBP.

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