If you are used to trading stocks, bonds, or commodity futures, you are accustomed to prices being quoted in dollars and cents. That’s not how it works in the Forex market. Currency pair prices are quoted in pips.
So what’s a pip? Pip is short for “price interest point.” You will also hear pips referred to as “basis points.”
In most cases, a single pip represents one ten-thousandth of a single unit of a currency. However, there are some exceptions, such as the Japanese yen, where a pip is one-hundredth of a yen.
Historically, a pip has been the smallest tradable price point in the Forex market, but currency dealers have recently made a move toward trading even smaller increments.
This started with “half-pip” pricing on pairs such as the EUR/GBP and the EUR/CHF, but it has since expanded so that some dealers are now quoting prices to one-tenth of a pip that’s going out five decimal places on most prices.
The Value of a Pip
So how much is a pip worth? That’s a great question, and coming up with the right answer depends on a few variables.
It isn’t like trading a stock, where you know that each penny that the stock moves up or down translates directly into a penny gained or a penny lost.
To calculate the value of each pip or each tenth of a pip as the case maybe you have to know which currency is the base/quote currency and how large the contract you are trading is, or the notional amount.
We’ll talk more about contract sizes when we discuss various investment vehicles in the Forex market, but for the time being, just know that full-size contracts cover 100,000 units of currency and mini contracts cover 10,000 units.
That being said, here is the formula you use to calculate the value of a pip:
(1 Pip/Exchange Rate) x Notional Amount = Pip Value
Let’s plug some actual numbers into that formula to illustrate. Suppose you want to know the value of a 1-pip move on a full-size contract on the USD/JPY (U.S. dollar vs. Japanese yen) currency pair at a time when the exchange rate is 82.65. To figure it out, you would use the following formula:
(0.01/82.65) x 100,000 = $12.10
Now suppose you want to know the value of a 1-pip move on a mini contract on the EUR/USD (euro vs. U.S. dollar) currency pair at a time when the exchange rate is 1.3387.
To figure it out, you would use the following formula:
(0.0001/1.3387) x 10,000 = €0.74699
Of course, if you want to know how much a pip is worth in US dollars and the USD is not the base currency, you are going to have to go through one more step to calculate the value of the pip.
To convert a pip value from a currency other than the U.S. dollar back into a dollar-based value, you simply look at the exchange rate of that currency pair using the following formula:
Pip Value x Exchange Rate – USD-based Pip Value
In the case of the EUR/USD example given earlier, the equation would look like this:
€0.74699 x 1.3387 = $1
You can do this conversion for any currency you want.
Okay, that’s enough math for now. It’s time to expand our horizons and talk about the global forces that drive these currency pairs, sometimes pushing them thousands of pips in no time at all.