Is the Presence of Pips Required for Engaging in Forex Trading? - Exploring the Definition of Pips in the World of Forex Trading
Why are pips necessary in forex trading?
If the pilot in the cockpit of your Boeing 747 is ready to take off, but then looks up and sees that none of the flight instruments are working, don’t tell him to simply put his foot on the gas and fly. Without his altimeter, compass, and airspeed indicator, he may be able to bring the plane up into the air, but he’ll have difficulty keeping his path steady, turning the aircraft properly, and dealing with unexpected events along the way.
Similarly, for a trader about to take off into the global forex market: It would be reckless to urge him to simply sign up for an online brokerage and start trading (which could be done quite easily). Before doing that, he needs to make sure his instruments are in good condition. This article is about one of the most important instruments in his forex trading cockpit: Pips.
In forex trading, you need to be able to determine how much money you stand to earn or lose on every trade. This is the only way one is able to decide whether a certain deal makes sense in the light of budget and goals. And only in this way will you be able to determine how much leverage would be appropriate per trade. In short, one should know how to use pips in trading because you’ll need them to keep your strategy deliberate, professional, and accurate.
Similarly, for a trader about to take off into the global forex market: It would be reckless to urge him to simply sign up for an online brokerage and start trading (which could be done quite easily). Before doing that, he needs to make sure his instruments are in good condition. This article is about one of the most important instruments in his forex trading cockpit: Pips.
In forex trading, you need to be able to determine how much money you stand to earn or lose on every trade. This is the only way one is able to decide whether a certain deal makes sense in the light of budget and goals. And only in this way will you be able to determine how much leverage would be appropriate per trade. In short, one should know how to use pips in trading because you’ll need them to keep your strategy deliberate, professional, and accurate.
Pips Trading – A day in The Life
A forex trader wakes up, checks the value of the AUD/USD pair, and finds it holding at 0.6439, which means that, in order to buy a single Australian dollar, he’d need to pay 0.6439 American dollars. He knows the US Federal Reserve is expected to hike interest rates later that day, which would likely boost the value of the USD against the AUD. He, therefore, decides to buy the US dollar by selling the AUD/USD currency pair. He wants to devote $15,000 to the deal, which he opens first thing in the morning.
Later on in the day, at 5 p.m., he glances at the exchange rate and sees the AUD/USD has dropped to 0.6354, which means it will cost you fewer US dollars to buy an Australian dollar. In other words, his prediction has come true, and American currency has appreciated against the Australian. But how much money has our trader earned on his deal?
As you’ll notice, the value of the AUD/USD fell by 0.0085. Another way of saying this is that it fell by 85 pips. “Pip” stands for percentage in points, and pips’ meaning in trading refers to the fourth decimal place of most currency pairs. (Therefore, if the AUD/USD had ticked up from 0.6439 to 0.6440, we’d say it rose by one pip.)
It’s fairly straightforward to calculate the value of our trader’s gains. We take the size of his deal ($15,000) and multiply it by the pip movement (0.0085) and come up with the figure of $127.5. Assuming our trader closes his deal at 5 p.m. that day, we can say he earned $127.5 on the deal.
Later on in the day, at 5 p.m., he glances at the exchange rate and sees the AUD/USD has dropped to 0.6354, which means it will cost you fewer US dollars to buy an Australian dollar. In other words, his prediction has come true, and American currency has appreciated against the Australian. But how much money has our trader earned on his deal?
As you’ll notice, the value of the AUD/USD fell by 0.0085. Another way of saying this is that it fell by 85 pips. “Pip” stands for percentage in points, and pips’ meaning in trading refers to the fourth decimal place of most currency pairs. (Therefore, if the AUD/USD had ticked up from 0.6439 to 0.6440, we’d say it rose by one pip.)
It’s fairly straightforward to calculate the value of our trader’s gains. We take the size of his deal ($15,000) and multiply it by the pip movement (0.0085) and come up with the figure of $127.5. Assuming our trader closes his deal at 5 p.m. that day, we can say he earned $127.5 on the deal.
Leverage and Pips
Let’s turn back the clock to the moment before our trader opens his deal. Instead of simply going ahead with it, he wants to know how much the use of leverage would alter the situation. His brokerage offers leverage of 30:1 on this forex pair, which means he could magnify the size of his deal 30-fold without adding any more capital of his own. Thus, if he took advantage of the maximum leverage, he could turn the deal into a $450,000 deal (30 times $15,000).
It seems to him a good idea, so he sets the leverage for his deal at 30:1 and presses “Deal” on his trading app. After that 85-point drop in the AUD/USD happens later on, we’ll now have to adjust our calculations to figure out his gains. Instead of $15,000 times 0.0085, it’s going to be $450,000 times 0.0085, and this amounts to $3,825. This is the sum total of his gains from his sell deal on the AUD/USD. Take note that, in the event the AUD/USD would rise instead of falling, his losses would also be multiplied in proportion to the leverage he used.
It seems to him a good idea, so he sets the leverage for his deal at 30:1 and presses “Deal” on his trading app. After that 85-point drop in the AUD/USD happens later on, we’ll now have to adjust our calculations to figure out his gains. Instead of $15,000 times 0.0085, it’s going to be $450,000 times 0.0085, and this amounts to $3,825. This is the sum total of his gains from his sell deal on the AUD/USD. Take note that, in the event the AUD/USD would rise instead of falling, his losses would also be multiplied in proportion to the leverage he used.
Example 2 for Pip Use in Forex
You want to open a “buy” deal on the EUR/GBP pair because you have reason to believe the euro is going to strengthen against the British pound. The complication here is introduced by the fact that your trading account is funded by neither of the two currencies in the pair but rather by US dollars.
You’d like the size of your deal to be $12,000, (for which you’d only have to put up $400 if you used 30:1 leverage). The rate of the EUR/GBP is at 0.7811 at the time of your deal. Later in the day, you are pleased to see the rate has increased by 65 pips to 0.7876. How much have you earned? To figure this out, you’ll have to take account of the difference in values between your account currency (US dollars) and the second currency in the pair (British pounds).
Take the relevant pip value (0.0065) and divide it by the USD/GBP exchange rate, which we’ll put at 0.8112, and you’ll come up with 0.0080. This is the pip value translated into your account currency. Now, multiply this number by your deal size ($12,000), and you get $96. This is the sum of your earnings on the deal.
You’d like the size of your deal to be $12,000, (for which you’d only have to put up $400 if you used 30:1 leverage). The rate of the EUR/GBP is at 0.7811 at the time of your deal. Later in the day, you are pleased to see the rate has increased by 65 pips to 0.7876. How much have you earned? To figure this out, you’ll have to take account of the difference in values between your account currency (US dollars) and the second currency in the pair (British pounds).
Take the relevant pip value (0.0065) and divide it by the USD/GBP exchange rate, which we’ll put at 0.8112, and you’ll come up with 0.0080. This is the pip value translated into your account currency. Now, multiply this number by your deal size ($12,000), and you get $96. This is the sum of your earnings on the deal.
Spreads and Pips
One of the things you’ll need pips for is calculating the value of the spread on a forex pair. The spread is the difference between the ask price of the pair (how much you’ll pay to buy it) and its bid price (how much you’ll get if you sell it). The reason why there is a spread is so that your trading brokerage can earn something from the transactions it facilitates.
Taking the EUR/USD currency pair as an example: You want to open a buy deal on this pair, but you’re not sure whether the amount you’ll lose on the spread makes the deal worthwhile. You check up on your trading platform and find the ask price is 1.0999, while the bid price is 1.0997, which makes for a two-pip spread. In the event that your deal size is $12,000, the value of 2 pips will be $2.4 (12,000 times 0.0002). With so little to lose on the spread, you elect to go ahead with the deal.
Taking the EUR/USD currency pair as an example: You want to open a buy deal on this pair, but you’re not sure whether the amount you’ll lose on the spread makes the deal worthwhile. You check up on your trading platform and find the ask price is 1.0999, while the bid price is 1.0997, which makes for a two-pip spread. In the event that your deal size is $12,000, the value of 2 pips will be $2.4 (12,000 times 0.0002). With so little to lose on the spread, you elect to go ahead with the deal.
Risk/Reward in Forex trading
No forex trader succeeds in every single deal. What they aim for is to earn more, overall, from their successful trades than they lose from their failed trades. This can be accomplished by succeeding more often than failing or, alternatively, earning more from successful trades than losing from trades that flop.
For instance, a trader may know he earns 18 pips from successful trades and tends to lose 12 pips on the losers. Because more comes in when he succeeds than goes out when he loses (a favorable risk/reward ratio), he would come out on top even if only half of his deals came through the way he hoped.
On the other hand, if he knows that, on the whole, he succeeds in 60% of his trades, he could compromise on the risk/reward ratio. In this case, even if he gains an equal number of pips on the successes than he loses on the failures, he’ll have a smile on his face at the end of the day.
Taking a practical example: A trader knows the success rate in his deals is 57%. He opens a buy deal on the EUR/USD, placing a stop-loss order five pips below the present rate. He also places a take-profit order ten pips above the present rate. He stands to gain twice as much from successful trades than he would lose from failed trades (10 divided by 5). Even if his success rate was substantially lower than 57%, he would still be on track to earn from his forex trading strategy. It would, therefore, make sense for him to continue on in the way he has been going.
For instance, a trader may know he earns 18 pips from successful trades and tends to lose 12 pips on the losers. Because more comes in when he succeeds than goes out when he loses (a favorable risk/reward ratio), he would come out on top even if only half of his deals came through the way he hoped.
On the other hand, if he knows that, on the whole, he succeeds in 60% of his trades, he could compromise on the risk/reward ratio. In this case, even if he gains an equal number of pips on the successes than he loses on the failures, he’ll have a smile on his face at the end of the day.
Taking a practical example: A trader knows the success rate in his deals is 57%. He opens a buy deal on the EUR/USD, placing a stop-loss order five pips below the present rate. He also places a take-profit order ten pips above the present rate. He stands to gain twice as much from successful trades than he would lose from failed trades (10 divided by 5). Even if his success rate was substantially lower than 57%, he would still be on track to earn from his forex trading strategy. It would, therefore, make sense for him to continue on in the way he has been going.
Wrapping Up Pips Trading in Forex
Foreign exchange rates are relentlessly chased upward and downward by interest rates, differentials in economic strength between nations, geopolitical tensions, and currency speculation. It’s a fast-moving, complicated arena in which to trade, and, therefore, those who enter into it need to be able to gauge their prospective deals quickly and efficiently. Growing familiar with pips in forex trading is a big step in the right direction. Pips can equip you to fly your forex trading plane smoothly and swiftly to your intended destination.
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