What is a Pip?
A pip is a unit of measurement for price movements of currencies in foreign exchange (FX) markets. Pip stands for “percentage in point” or “price interest point.” It represents the smallest price variation that a particular exchange rate experiences based on typical FX market convention.
Currency pairs are generally traded on a pricing convention that includes four decimal places, with the pip representing the very last decimal point. Therefore, we can see that a pip is equivalent to 0.0001. It is also the same as a basis point (bps), which is another common unit of measurement for percentages.
As an example, if the CAD/USD exchange rate were to move from 1.2014 to 1.2015, the change in value would represent one pip.
Why Use Pips
Since foreign exchange markets are highly liquid with a high volume of transactions, the units of measurement for transactions are important. Furthermore, since units are typically quite small, a larger number of decimals are needed to capture variations in exchange rates to a greater degree of accuracy.
Foreign exchange markets are important due to their role in facilitating cross-border transactions, trade, and investments. If one country wants to invest or purchase goods from another country, they will need to utilize the FX markets to complete that investment/transaction.
In addition to international trade and business, the FX market also facilitates hedging and speculation activities for market participants. Due to the FX markets’ wide array of uses, pips are very important for determining how much market participants will pay in their currency trades.
Pips cannot be used in every context, though, and in an environment of hyperinflation in currencies, exchange rates become difficult to calculate with pips. Hyperinflation refers to a period where prices of goods and services are increasing excessively and in an out-of-control fashion. When FX movements become extremely high, pips lose their utility.
One such example was recorded in Zimbabwe in 2008, where monthly inflation rates exceeded 79 billion percent in the month of November. When hyperinflation occurs, units of currency increase at an extraordinary rate, which makes the small measurement of pips useless.
What is the Value of a Pip?
The value of a pip will depend on the particular trade that is being executed. An important factor within a specific trade is the lot size that is being traded. A lot size is simply the quantity of a currency unit that is being traded. There are various different lot sizes, including:
- Standard Lot – Considered to be 100,000 units of a currency
- Mini Lot – Considered to be 10,000 units of a currency
- Micro Lot – Considered to be 1,000 units of a currency
How are Pips used in FX Markets?
An important measure in trading is the bid-ask spread. The spread represents the difference between what price a buyer pays and what price a seller receives. In FX markets, the bid-ask spread would be represented in the difference between the prices, measured in pips.
The bid-ask spread represents the profit that will be made by the FX broker of a transaction. For example, if a currency is purchased at the ask price of 0.9500 and being sold at the bid price of 0.9505, then the broker would profit on the difference between the two:
0.9505 – 0.9000 = 0.0005 or 5 pips
Since FX markets are highly liquid, bid-ask spreads are generally very small, especially for highly traded currencies such as the US dollar, British pound, Japanese yen, etc. For this reason, there is another unit of measurement known as fractional pips, or pipettes, which are an additional decimal point further than a pip (five decimal points). The greater division allows for more flexibility on pricing and spreads of highly liquid currencies.
Making Trading Decisions
Since pips represent price changes of currency pairs, they are important for making decisions. As mentioned above, FX markets are widely used by various participants in functions related to international trade, international investment, speculation, and hedging activities. All participants will monitor changes in FX markets to inform their decisions.
A country may determine its trading partners depending on favorable FX movements. Similarly, an investor or speculator may try and profit from views in the FX market. For example, an investor may expect the US dollar to appreciate in value relative to the Canadian dollar. If the current exchange rate is 1.2205 CAD per USD and changes to 1.2210 CAD per USD, then the profit is:
1.2205 – 1.2210 = 0.005 or 5 pips gained
Thank you for reading CFI’s guide to Pip. To keep learning and developing your knowledge base, please explore the additional relevant resources below: