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PIPS AND PROFITS

What is a PIP?

 

A PIP (a “Percentage in Point”) is a way of measuring increases and decreases in currency exchange rates. It’s the smallest unit of currency rate fluctuation and corresponds to the last decimal place of an exchange rate. Here’s an example: the Euro / US Dollar (EUR/USD) exchange rate is quoted to four decimal places, for example 1.4035. If this is the rate for buying, then it means you need to pay 1.4035 US Dollars for each Euro that you buy. The PIP in this case is simply 0.0001.

 

So what is a PIP worth?

 

Calculating the value of a PIP (also known as a point) lets you know how much profit (or loss) a particular deal is making you. The value of a PIP is calculated with reference to the US Dollar (because this is the most important currency on the market today). In our example above, we have an exchange rate of 1 Euro to 1.4035 US Dollars, so we divide 0.0001 (the PIP unit) by 1.4035 (the USD exchange rate) to get a PIP value of 0.0000712.

 

How do you make money if the PIP value is so small?

 

Pip values are really just a matter of definition. What is much more important is what happens when you multiply a few pips by a larger amount of currency.

 

Let’s go back to our example again. Suppose you bought Euros using US Dollars at an exchange rate of 1.4029. In Forex trading, brokers often allow their customers to buy relatively large amounts of currency even if their initial investment is quite modest. Just to reassure you, the risk for the customers is still limited to their initial investment, no matter what the amount of currency being bought or sold (see also the section on “Leverage” for the other possible consequences of doing this). So you might buy a quantity of Euros worth $10,000 or even $100,000.

 

Now suppose the exchange rate for EUR/USD goes down to 1.4004, a difference of 25 pips. This can happen very rapidly. If you now sell your Euros back, you’ll get more US Dollars for them than when you started. If you’d started with $100,000 of your broker’s money, a quick calculation shows that you’d make a profit of $185. You might have to pay some of this as a broker’s commission or fees, but you can see how this can start to generate larger and larger profits.