What Are Pips in Forex Trading?
The foreign exchange (Forex) market is the largest in the world, with $3.2 trillion in currency traded on average each day as of 2007. Yet Forex trading turns on very small changes in exchange rates---usually less than a penny. Price movements are so minute that the smallest possible change is significant. The smallest changes are called pips in Forex trading and they play a role investors must be aware of before trading on the Forex market.
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Identification
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Percentages in point, or pips in Forex trading, are defined as the smallest possible change in the exchange rate between two currencies. In everyday situations, the smallest increment is a penny. For example, when a retailer decides to change the price of a product, the change must always be at least one cent. Thus, one penny minimum is the "pip" in ordinary transactions.
Types
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For a Forex trade, one currency is paired with one other currency. Since each is different, the pip for each currency pair is slightly different, although usually about 1/10,000 per unit. For instance, the most widely traded pair is the US dollar and the Euro. The pairing might be quoted using the ISO (International Organization of Standardization) code as EUR/USD = 1.4054. This means that it costs $1.4054 to buy one Euro. The pip is defined by the last digit. For the EUR/USD pair it is $0.0001 or 1/100 cent.
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Function
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Pips in Forex trading play a key role in how the cost of a trade is determined. A currency buyer will offer a bid and a seller an asking price. The spread (difference) between the two is extremely small, just 1-2 pips for currency wholesalers. Retail dealers (usually called brokers) mark this up to 3-20 pips (though usually no more than 10). Forex dealers do not charge commissions. Instead they keep the sum represented by the spread as their fee. The objective f Forex trading is simple. Traders try to anticipate which way the market will move. If they guess right, and the price change exceeds the spread, the trade is profitable. Otherwise, the trader loses money.
Features
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Forex trading is done on margin. The market is virtually unregulated, so brokers can set whatever margin requirements they wish. Margin ratios are extremely high, typically 50:1, 100:1, and up to 400:1. The last indicates you can purchase a lot of $100,000 by putting up 1/400 of that amount of your own money ($250). The value of one pip for this amount is $10. Under these circumstances, even a tiny change in the exchange rate will result in large gains or losses, making Forex trading both a potentially high profit and very high risk form of trading.
Considerations
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Before you try Forex trading, learn how factors like national monetary and trade policy, news events, and market trends affect exchange rates. Some dealers allow you to set up "practice accounts" and you should use these to learn trading strategies and risk management. It's also important to deal with a reputable broker. The best way to do this is to choose one who is a member of the National Futures Association and has agreed to comply with their standards. Good brokers/dealers will provide real-time quotes, online trade execution software, and reasonable prices.
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