In the foreign exchange market, the percentage in points refers to the smallest unit of a currency price and is equal to 0.0001. One exception is for the Japanese yen, which is quoted only to the second decimal point. Pips are also sometimes referred to as points and are useful for measuring a change in the price of a currency or the spread between two prices. Measuring pips is easy, but interpreting them as profits or losses can be tricky and depends on the quoting convention used. An investor in the United States might trade euros in the spot market, for example, where trades are settled based on current market values.
Interpret the initial quote by by noting which currency is listed first in the pair of currencies being exchanged. In the spot market, the first listed currency indicates which currency is being bought or sold and is called the base currency. Determining the base currency allows you to determine whether the measured pips represent a profit or loss. For example, consider a EUR/USD ask price of 1.3166. The euro is the base currency because it is the first listed in the currency pair. This means that U.S. dollar is the quoted currency (which you are using to buy or sell the base currency), and is always expressed in terms of one unit of the base currency. If you were to speculate that the euro will appreciate in value, then you would take a long position, that is, buy the euro.The ask (or offered) price is from the market maker's perspective so this indicates that you can buy one euro for $1.3166 U.S. dollars. If you buy the euro (also called taking a long position) and the measured pips are positive, it represents a profit. If you sell the euro (also called taking a short position) and the measured pips are negative, it represents a loss.Step 2
Subtract the new quote from the old quote to determine the change in price. Let’s assume your bet that the euro would appreciate was in the right direction, and it now takes more dollars to buy one euro. Let’s say the bid-price, the price the dealer is now willing to buy at, is now $1.3189. From your perspective the Euro has appreciated by $1.3189 – $1.3166 = $0.0023.Step 3
Count from the fourth decimal place. In our example, the profit per euro of $0.0023, can be expressed as 23 points or pips.
- A pip is very similar to a basis point in the bond markets. A basis point is also 0.0001 = 0.01 percent, but refers to an absolute increment in a rate. For example, if interest rates are currently 2.03 percent and then increase by 3bps, the new interest rate is 2.06 percent. In contrast, a pip in the FOREX markets refers to an increment in the price of a currency. For example, the EUR/USD might increase 5 pips from 1.3160 to 1.3165.
- Pips may be expressed in dollars for a particular lot size by multiplying the number of currency units in the lot by 0.0001 (or by 0.01 for the yen). One pip for a standard lot (for example, 100,000 euros) is $10. Similarly, for a mini-lot of 10,000 Euros, a pip is $1. A micro-lot is 1,000 Euros. Therefore by multiplying 1,000 times one pip of $0.0001, we find the dollar equivalent of one pip for a micro-lot is $0.10. Note that some dealers allow trades in smaller lots, down to one unit of currency. If in our example we traded one mini-lot, the profit is $23.
- It is possible for a foreign currency fund manager to express fees in terms of pips. If the manager charges 5 pips per trade, for example, the $23 profit in our example above would be reduced by $10, which includes $5 each for the opening trade and the closing trade. As with all fees, such an arrangement must be disclosed.
Kathryn Christopher has been writing about investments for more than 20 years. Her work has appeared in the "Journal of Alternative Investments" and numerous other academic and industry publications. She works at Wiggin Financial Planning, teaches for UMASSOnline from South Florida, and holds a PhD in finance from the University of Massachusetts.