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Pips In FX

September 6, 2022
Understanding pips in forex

Pips in forex are the incremental price movements of currency pairs on the foreign exchange market. The term is an acronym for “price in percentage” or “percentage interest point”. When the price of a currency pair moves up or down, the extent of this movement is measured in pips, which are represented on the interface of your trading platform dashboard.

One pip is generally a tiny amount and worth far less than a single dollar and even less than a single cent. Despite this relatively small scale, pips are very important to traders — traders are working with such acceptable margins that they must remain aware of even the most minute price movements. These movements are instrumental as traders plan their strategies and examine their open positions.

Different definitions of trading pips

Trading pips can be defined in different ways. This is because the idea provides a valuable metric for traders examining the movements of the currency pairs. For currencies with tiny denominations, a pip may be defined differently to currencies with larger denominations.

For most currency pairs, a pip will be a movement at the fourth decimal place. The example of the AUD/GBP currency pair — comparing the Australian Dollar as the base currency and the British Pound as the quoted currency — this might be represented as 0.5768. So one Australian Dollar is worth 0.5768 British Pounds. If this value rises to 0.5769 or falls to 0.5767, this would be a movement of one pip.

But putting the pip at the fourth decimal place may be too precise in some cases. For instance, in the AUD/JPY pair — the Japanese Yen is the quoted currency; the Yen is a currency with tiny denominations, so we need to define a pip differently. With this currency pair, a pip would be found at the second decimal place, as a movement at the fourth decimal place is too small to provide any actionable insight.

Alternatively, some traders may want to view price movements in even greater detail. For example, they may decide to look at pipettes rather than pips — this means adding another decimal place to the reading. So, in the instance of the AUD/GBP pair — and most other pairs — a pipette will be at the fifth decimal place, ten times smaller than a pip. In the example of the AUD/JPY pair, the pipette will still be ten times smaller than the pip but will be found at the third decimal place.

How pips work with forex derivatives

Forex traders can use different techniques and strategies to approach the foreign exchange market. While all of these strategies, techniques and fx derivatives are different in their ways, they are united by one key aspect — all rely on price movements measured in pips. Take a look at how pips are used across these different forex strategies.

  • Pips and forex futures

When traders use forex futures contracts, they agree to buy a predetermined amount of a set currency at a locked-in price. Futures traders can use forex pips to examine whether or not the contract was the right choice, based on the price movement, although they will still be obliged to make the trade at the end of the contract period.

  • Pips and forex forwards

Forwards are similar to futures in that they are obligated to complete the trade and involve predetermined currencies, set periods, and locked-in prices. However, they are not traded on the exchange platform and are sold OTC (over the counter) via a broker. Traders will assess the success of the forward contract by examining price movements measured in pips.

  • Pips and forex options

Again, options involve predetermined factors such as currency type, time duration, and a locked-in purchase value. However, there is no obligation to complete the trade at the end of the contract period. With this in mind, traders will use pips to decide whether or not they should go through with the trade when the contract expires.

  • Pips and forex swaps

With a forex swap agreement, parties agree to trade one currency for an equivalent value of another over a set period. Interest is paid on the trade, and the transaction is reversed at the end of the agreement period. Pips are essential for analysing the progress of the trade, as well as for planning future swaps.

  • Pips and forex spot trading

Spots are not derivatives but an essential aspect of forex trading. Engaging in spot trading means opening positions based on the current value of a currency pair. Analysing pips helps traders to understand potential market movements as they decide whether or not to execute a spot trade.

How pips work with forex leverage

Pips are vital when it comes to using leverage in forex trading. When traders use leverage, they borrow capital to supplement their money. Traders can choose to use only a small amount of leverage, or they can leverage at a higher ratio, significantly increasing their exposure to market forces.

For example, a trader may choose to leverage a trade at a ratio of 10:1. This means that for every $1 they use to open the position, they borrow $10, achieving 10x the exposure. At 20:1, this rises to 20x, and so on. When leveraging, traders can potentially experience increased profits multiplied by the magnitude of the leverage ratio. However, the potential losses are multiplied too, so leveraging should be handled with extreme caution.

So what does this have to do with pips? Trading on leverage magnifies everything, including pip values. While a single pip movement may only result in a tiny profit or loss on an un-leveraged trade, leverage multiplies this value. At 10:1, each pip is worth 10x as much; at 100:1, each pip is worth 100x as much. Generally, these increases are limited at 500:1 — usually, the maximum amount of leverage permitted on a trading platform.

Pips and beginner traders

When beginners learn how to trade FX currency pairs, they will need to get used to the interface they are using while also growing their understanding of the tools and indicators necessary to execute trades. Pips are among the first things beginner traders will have to do.

As traders become more confident, they can use advanced indicators and tools to forecast future movements in the forex market. While these indicators and tools cannot guarantee future successes — and traders of all experience levels can suffer losses in the market — they help develop a more sophisticated and diverse strategy. However, traders need to know how to read and analyse pips to get to this point. Forex tickers and graphs are all based on information provided by these pips.

This is why demo accounts are so helpful as individuals learn how to trade forex. With a demo account, traders can get used to looking at incremental price movements and analysing the direction of these movements over time — all in a risk-free environment. As no money is changing hands, there is no potential for profit when using a demo account, but there is no potential for losses. This makes demo accounts a vital asset for traders starting on their journey.

The benefits of understanding forex pips

Gaining a solid understanding of pips provides many different benefits to forex traders. Learn more about some of the essential advantages: 

  • Quick and reliable insight

Perhaps the most significant advantage of understanding forex pips is gaining immediate insight. Forex price changes happen quickly and are delivered in real-time. As a result, traders need to be able to check their platform’s interface and understand these changes at a glance, and pips are a big part of this.

  • An understanding of past price movements

Pips also give traders the ability to view and understand past price movements. These price movements do not guarantee future movements in the same direction, but they help traders make informed predictions.

  • A more knowledge-based approach to leverage

Leverage effectively magnifies the impact of minute pip movements. Therefore, understanding pips is crucial for traders seeking to get the most out of their leveraged positions.

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