In Forex (foreign currency) trading, profit or loss depends on very small changes in the value of one currency measured against another. The price movements are small enough that even the least possible change becomes important. And that’s exactly what a pip is: the smallest possible change. The pip plays a central role in the mechanics of a Forex trade. It’s vital that you understand pips if you want to try your hand at Forex trading.
A pip (short for percentage in point) is formally defined as the smallest increment by which a price can change. To take an everyday example, when you go shopping you will sometimes notice that the price of a product you buy regularly has changed, but the change will never be less than one cent. A penny is the smallest denomination used--and so one penny is the pip.
The size of a pip in Forex trading depends on which currencies are being exchanged. Currencies are always traded in pairs whose relative value is expressed using International Organization for Standardization (ISO) codes. For example, if the Euro costs $1.30 (U.S.) at a particular time, this is written EUR/USD = 1.3000. The price can change by as little as $0.0001 (here, to 1.3001). For this currency pair, the pip is $0.0001, or 1/100 cent. Because each currency is different, the pip will differ from one currency pair to the next, but are usually of similar size.
To understand the role pips play in Forex trading, you also need to know how the bid/ask spread in pricing works. A seller will have an asking price and a buyer a bid price. The difference between the two is called the spread. For currency wholesalers, the spread is only 1 to 2 pips. Retail brokers mark the spread up to as much as 20 pips (though usually it’s less than 10). Forex brokers don’t charge commissions. Instead, they keep the sum represented by the spread. Put simply, when you enter into a Forex trade bet, the exchange rate of a currency pair will move in one direction or the other. If you are right and the change is greater than the spread, you make a profit. If you are wrong you lose money.
What makes Forex trading potentially very profitable, and always very risky, is that trades are done on very high margins. Forex margins can be 30:1, 100:1 and up to 400:1. This means you can put down as little as $250 with a 400:1 margin and buy a “lot” of $100,000 worth of a foreign currency. Each pip is equivalent to $10. If you beat the spread by even a few pips, you can make a profit of 20 percent, 50 percent, 100 percent or more. Of course, if the price goes the other way, you can lose money just as fast.
To trade on the Forex market, you need a good broker. There is no formal regulation of Forex dealers, but you can choose one who is a member of the National Futures Association and abides by its standards. Your broker should provide real-time quotes, good trade execution software and reasonable prices. Even more important, you have to learn about the currency exchange market and what causes rates to go up or down. Learn to understand how news, trade and monetary policy, and market trends influence changes in prices. Learn and use strategies to control risk--and to keep yourself calm in the heat of trading.