Lesson #3: Introduction to Forex Pips

You are going to perform a little math here. Probably you have already heard about pips and lots. In this section, you will learn how to understand these pips and lots and how to calculate them. You need to take time to understand the information here. Knowing the concepts here will be required in your Forex trading. You should never start trading without understanding the values of pip and the methods of profit and loss calculations.

What is a pip?

Pip is the most commonly used increment of currencies. A 1 pip movement of EUR/USD means it goes from 1.2250 to 1.2251. The last decimal point would be the pip. This is also your indicator for calculating profit and loss. Each currency in the market has its particular value. It would be important to calculate the pip value of each currency. In a pair where the first quoted currency is the USD, this is the calculation:

If you take the USD/JPY pair at 119.80 (you have to note that this currency only have 2 decimal places; the standard is for currencies to have 4 decimal places.)

So, USD/JPY = 1 pip is equal to .01

Therefore:

USD/JPY:

119.80

.01 divided by exchange rate = pip value

.01 / 119.80 = 0.0000834

This might seem very long numbers but a discussion for this will follow at calculating lot size.

USD/CHF:

1.5250

.0001 divided by exchange rate = pip value

.0001 / 1.5250 = 0.0000655

USD/CAD:

1.4890

.0001 divided by exchange rate = pip value

.0001 / 1.4890 = 0.00006715

In pairs that the Dollar is not the first quoted currency, you need to add an extra step to get the value of the US Dollar.

EUR/USD:

1.2200

.0001 divided by exchange rate = pip value

therefore

.0001 / 1.2200 = EUR 0.00008196

You need to return to the Dollar so the extra calculation would be:

EUR x Exchange rate

So

0.00008196 x 1.2200 = 0.00009999

When you round it up, this would be 0.0001

GBP/USD:

1.7975

.0001 divided by exchange rate = pip value

So

.0001 / 1.7975 = GBP 0.0000556

Again, you need to get back to the Dollar so you should make an extra calculation which is:

GBP x Exchange rate

So

0.0000556 x 1.7975 = 0.0000998

When you round up this number the result is 0.0001

Probably you are getting dizzy with these numbers. You might think that you will have to work this out alone. Fortunately, Forex brokers will help you sort out these numbers. It is best however to learn how they do these sort of things. The next part will teach you how these small amounts can add up.

What is a lot?

When you trade in spot Forex, you will be trading in lots. $100,000 is the standard size of a lot. For Mini lots, the standard is $10,000. You know by now that the measure of currencies is called pip. This is the smallest increment reflected in decimal point. Because pips are very puny, you need to trade huge amounts for you to see large profit and loss. Assuming you used the standard $100,000 lot size. You can now recalculate the examples and see how this will impact on the pip value.

USD/JPY at an exchange rate of 119.80

(.01 / 119.80) x $100,000 = $8.34 per pip

USD/CHF at an exchange rate of 1.4555

(.0001 / 1.4555) x $100,000 = $6.87 per pip

When the US Dollar is not the first quoted pair, the calculation formula would be a little different:

EUR/USD at an exchange rate of 1.1930

(.0001 / 1.1930) X EUR 100,000 = EUR 8.38 x 1.1930 = $9.99734 rounded up will be $10 per pip

GBP/USD at an exchange rate or 1.8040

(.0001 / 1.8040) x GBP 100,000 = 5.54 x 1.8040 = 9.99416 rounded up will be $10 per pip.

Some brokers may have different methods of calculating pips in relation to the sizes of lots. However, they will still be able to provide you the accurate pip values of currency at any given time. Every time the market moves, the pip value will move also. Of course this will depend on what currency pair you are trading.

How do I calculate the profit/loss?

So you will be very familiar with pip value calculations by now. It is time to learn how to calculate your profit and loss.

For such purpose, buy USD and sell Swiss Francs.

The rate quoted for you is 1.4525 / 1.4530. You are buying Dollars so you need to work on the 1.4530. This is the rate that traders will sell.

You buy 1 lot of $100,000 at 1.4530.

In a few hours, the currency price moves to 1.4550 so you decided to close your trade.

The fresh quote now is USD/CHF is 1.4550 / 1.4555. Because you closed your trade by buying which is your entry to the market, you can now sell and take the 1.4550 as your closing price. This is the amount that traders are willing to buy.

You will get a difference of 20 pips because 1.4550 less 1.4530 is .0020.

By utilizing the formula discussed before, you now have (.0001/1.4550) x $100,000 = $6.87 per pip x 20 pips = $137.40

Take note that as you enter or exit a trade, you will be subject to the spread of the bid and offer quotes.

If you buy, you have to use the offer price of a currency. If you sell, you have to utilize the bid price.

When you order buy, you will pay the spread the minute you enter the trade but not when you exit. On the contrary when you sell, you will not pay anything for entering trades but will have to pay upon your exit.

What is leverage?

By now, you might be wondering how you can trade such large amounts when you are just a small trader. You can compare your broker with a bank who will give you a loan of $100,000 as long as you make a $1000 deposit. The broker will hold this deposit but will not keep it. You should not be surprised by this arrangement because this is how Forex leverage works.

Your broker and your confidence will dictate the amount of leverage you can use.

You will be required by the broker to have minimum account size. This is also known as account margin or initial margin. After your initial deposit, you can instantly trade at the Forex. You will be notified by the broker about your specific trade position (lot).

In such cases, if you deposit $1,000, your 1 lot would be $100,000. If you deposit $5,000, you can trade up to $500,000.

The security margin for each lot varies from broker to broker. In the example, your broker provides a requirement of 1 percent margin for you. So every time you trade $100,000, you will have to deposit $1,000 for your position.

What is Margin Call?

In case the amount in your account drops below the allowable margin requirement, your broker will automatically close all or some of your open positions. This is a protection so your account will not incur negative balance. This will happen even when the market is highly volatile.

Example no1

You might be willing to open an initial account with $2,000 (not smart). Then you open 1 lot EUR/USD with $1,000 margin requirement. Your usable margin will be the amount available to open new trades or absorb losses.

Because you have $2,000 in your account, your initial usable margin is $2,000. Once you open 1 lot, your usable margin becomes $1,000 because 1 lot requires $1,000.

If you are unlucky and your losses go beyond your usable margin, a margin call will be initiated.

Example no2

You can open a regular account with $10,000. You also have a $1,000 margin requirement for 1 lot EUR/USD trade. If you do not have any open trades after your deposit, your usable margin is $10,000. But because you entered the market with 1 lot, your usable margin becomes $9,000 because you have a $1,000 used margin.

You get a margin call if you incur losses above $9,000.

Usable margin and used margin are different so you should know this.

Your broker will close your positions if your account falls below the usable margin unless you make another deposit. The broker wants to limit your risk and his risk that is why your positions will be closed. Essentially, you will not incur losses above your initial deposit.

Carefully read the broker’s policies on margin accounts especially if you will trade on the margins.

It is also normal that most brokers will increase the margin requirements during weekends. For example, on weekdays you will have 1 percent margin but if you remain in the position over the weekend, the margin will be 2%.

Some say that using too much margin would be very risky and dangerous. That is why margin requirement is a subject of heated debates among many traders.

On your part, the best thing you can do is to understand your broker’s policies about margins. You also have to be comfortable with the margin you are using. You also need to understand the level of risk you are taking when you leveraged too high.

Leveraging is described in two ways. Some brokers use ratio while others use percentage. This is how leverages are described by the brokers:

Leverage = 100 / Margin Percent

Margin Percent = 100 / Leverage

Leverage is usually displayed in terms of ratio such as: 100:1 or 200:1.