- Pips
- Lots
- How much is a pip worth
- Combining pips and lots to see how much you have at risk
We discussed in the last article how prices are quoted in the FX market. In this article I’d like to go into a bit more detail on that subject, with pips and lots.
PIP
A pip has traditionally been the last decimal place that the currency is quoted to. As a result, it was also the smallest increment that any FX pair can move. For example, putting aside the spread, if EUR/USD is being quoted at 1.1000, then it could either rise one pip to 1.1001 or fall one pip to 1.0999.
Now it used to be that this was indeed the smallest increment that EUR/USD could move because the pair was only quoted to 4 decimal places. But since 2005 the major currencies are being quoted to one more decimal place, giving rise to decimal or fractional pips (1/10 of a pip). So now currency pairs such as EUR/USD and GBP/USD are often quoted to five decimal places. A pip is still the fourth decimal place, but the pair can move less than one pip.
Similarly, USD/JPY used to be quoted to two decimal places, but now it’s often quoted to three decimal places. A pip is still the second decimal place, though.
Lots
If you’re going on a trip, you can buy or sell however much foreign currency you want. You can go to a bank in Japan and change $200 into yen to cover a couple of day’s expenses, for example,
However, when you’re trading FX as an investment, you usually trade a standard amount of money.
One standard lot in the FX market is 100,000 units of the base currency. That’s the currency on the left of the currency name, remember. This would mean €100,000 if you’re trading EUR/USD, $100,000 if you’re trading USD/JPY, £100,000 if you’re trading cable, etc.
There are also mini-lots of 10,000 units and micro-lots of 1,000 units. A micro-lot is usually the smallest available unit for trading.
HOW MUCH IS A PIP WORTH?
Now, here’s where these two units become important. You can combine them to figure out how much money you’re making or losing on your trade.
When trading a standard lot of 100,000 units of the base currency, the value of the movement of 1 pip is 10 units of the quotecurrency for most currencies that are about the same size. That means a 1-pip movement in a standard lot of EUR/USD is worth $10, a 1-pip movement in a standard lot of USD/CAD is worth CAD 10, etc.
For example, let’s say you sell 1 lot of EUR/USD at 1.1000. That means you take €100,000 and change it into USD at 1.1000. This leaves you holding $110,000. Let’s say EUR/USD falls one pip to 1.0999. You could then change your dollars back into €100,009.09 for a gain of €9.09 or $10.00. On the other hand, if EUR/USD rises by 1 pip to 1.1001 and you then change your money back into EUR, you’d only get back €99,990.91 for a loss of €9.09 or $10.00.
As you can see, although you are working with a certain amount of euros (your base currency), your profit or loss is in dollars (your quote currency). That is to say, your profit or loss is quoted in the quote currency.
The value is similar but the digits are of course different for a currency pair like USD/JPY. In this case, each pip is worth 1,000 of the quote currency (which is close to but not exactly $10). For example, if you take $100,000.00 and convert it into yen at ¥130.00 you would have ¥13,000,000.00. A rise in USD/JPY to ¥130.01 would mean your yen are now worth only $99,992.31 for a loss of $7.69 or ¥1,000.00.
A simple way to calculate your profit or loss on your position then is to multiply the size of the position in the base currency by the pips the pair moved. That will give you your profit or loss in terms of the quote currency. Of course, when doing the calculation, pips have to be adjusted to the proper decimal place that they really represent
So for example: if you bought €100,000 of EUR/USD times a 10-pip move gives you 100,000 X 0.0010 = $100.00. If you sold $100,000 of USD/JPY times a 50-pip move, that would equal = 100,000 X 0.50 = ¥50,000.00.
COMBINING PIPS AND LOTS TO SEE HOW MUCH YOU HAVE AT RISK
Since 2013, the average daily range of EUR/USD has been around 100 pips a day. So let’s say you manage to enter the market at exactly the middle of the day’s range. That means your risk is around 50 pips. In EUR/USD, this would mean your risk on a standard lot is 50 X $10 = $500.
This calculation of course depends on two assumptions, both of which may be wrong! It assumes A) average volatility and B) you getting into the market at the exact middle of the range. It’s quite possible that volatility is higher than average and you’ve gotten in at one end or the other of the day’s range. In EUR/USD, although the average range is around 100 pips, a range of around 160 pips is normal (technically speaking, the one standard deviation range or 66% of the time). If you got in at the bottom 1/3rd of that range, you might easily be subject to a move of some 110 pips or $1,100.
What we can see from this is that when trading one standard lot, a $1,000 account can be wiped out in a normal day’s trading, while there’s a good chance that an account with $500 in it probably will be wiped out.
Conclusion?Make sure there is sufficient money in your account so that you can withstand normal market movements without getting stopped out. That means either depositing enough money to support the size that you want to trade or making sure that you trade in lots small enough to suit the money in your account.
SUMMARY
A pip is the smallest whole unit that a currency can move, while a lot is the normal amount of a currency that you trade. Combining the two gives an easy way to calculate how much money you’ve made or lost on any day. It also allows you to see if you have enough money in your account to withstand the normal ups and downs of the market.
For the book:
It’s unclear where the term pip came from. A pip refers to a small hard seed in a fruit and from there a very small thing. I think the term might have come from that.
The Oxford English Dictionary says the term used to be used for the spots on playing cards, dice or dominoes, and from there became used to mean a step or degree. That would make sense in that a pip was the smallest increment that a currency pair could move.
Others think it is the FX market’s equivalent of the bond market’s basis point, or bp (meaning 1/100th of a percentage point, or 0.01%, the smallest increment that most bond yields move). Some sources say it stands for “percentage in point” or “price interest point,” but that seems to me to be people trying to figure it out after the fact.
You can go back and recalculate the average and normal ranges more precisely.
