Pips and 'pips values' represent one of the most misunderstood concepts in Forex trading. Newbies, especially, often have trouble grasping the idea behind pips -- but, a solid understanding of pips is crucial to successful Forex investing.

 

If you've had trouble with pips, then today may be your lucky day. I'm going to attempt to clarify things once and for all with a brief pips tutorial.

 

Hopefully you're already familiar with the concept of 'basis points'. One basis point is equal to one one-hundredth of one percent, and represents the smallest increment of change measured for any financial instrument.

 

Take interest rates as an example. If the interest rate on your credit card rises from 10.12 percent to 10.13 percent, then it has risen by 1 basis point.

 

Pips are the Forex market's version of basis points. Let's say that the exchange rate for the EUR/USD pair move from 1.4465 to 1.4468. This movement represents a shift of 3 Pips, and may be good or bad depending on which currency you are holding.

 

Here's the catch, though. Notice that the shift took place on the 4^th decimal, which is the ten-thousandths place, or 1/10,000 of a percentage point? You have a shift of one ten-thousandth instead of one one-hundredth.

 

The reason for this is that most currencies (with the exception of the Yen) are quoted out to four decimal places. This means you get to take advantage of even the most minute shifts as you trade on high volume.

 

In order to calculate Pips for the common, four decimal currency pairs, you must divide the value of 1 Pip by the exchange rate:

 

1 Pip = 1/10000^th / exchange rate

 

Now, what happens when you are dealing with the Japanese Yen?  In this currency pair, we find an exception to the rule because the Yen is quote out only to the hundreds place, or 1/100.

 

For the USD/JPY pair (or vice versus), your formula would be:

 

1 Pip = 1/100^th / exchange rate

 

Now that you know how to calculate Pips for any currency pair, you must look at what an actual Pip is worth to you in real dollar terms. This value is known as “pips value'. In order to do this, we must bring 'lot size' into the equation.

 

 

 

If you purchase a standard lot of 100,000 pairs of EUR/USD at 1.4465. , your formula will be as follows:

 

Pip Value = (0.0001 /  1.4465) x 100,000 = 6.91

 

So, a pip at this exchange rate is worth 6.91 Euro. Don't look for exact numbers here. What you need to pay attention to is the fact that '6.91' represents the average gain or loss per change in pips.

 

In other words, a fluctuation of 2 pip from 1.4465 to 1.4467 isn't going to raise your profit or loss by a full Euro or more.  Try doing the calculation for a 2 pip rise, and you'll see that your pips value goes up only to 6.192.

 

I recommend getting comfortable with these basic calculations first, and then moving on to the calculations of actual profit and loss, which will require you to factor in bid price and ask price.

 

Also, remember that your online broker usually calculates pip and pips values for you, and you don't have to know how to do the math. It's just good business to be able to do it yourself.