Pip is the most primary unit of measure used to trade currencies. It is the smallest amount by which a currency quote alters which is typically $0.0001 for US dollar related currencies or 1/100 of 1%. The final decimal place of a quotation is a pip. This defined size helps to safeguard investors from heavy losses. Most currency pairs go out to 4 decimal places. The only exception is the Japanese yen which goes out to 2 decimal places.
In the global currency markets investors have their accounts denominated in different currencies. Thus, the pip value will have to be evaluated for whatever currency your account is traded in. The monetary valuation of each pip is determined by three factors-the currency pair being traded, the magnitude of the trade and the exchange rate. The fluctuation of a single pip can impact the value of your trading position. Thus simply put, a pip in Forex terminology is a unit for calculating profits or losses.
The value of pips for your trades can vary depending on your lot size. When your trade is positive in pips then you are registering profits and when it's negative then you are in the red. Few forex firms let trades progress in fractional pips. That allows for even firmer control on profits & losses and offers flexibility on spreads. Because pips are tiny in value, forex trades in micro lots, mini lots and standard lots: 1,000, 10,000 or 100,000 units of currency. To enumerate pip value, divide one pip (usually 0.0001) by the existing value of the currency pair. Then, multiply that number by your lot size: the number of base units that you are trading.
Pip value example
If EUR/USD is trading at 1.8000 and you are trading the equivalent of 100,000 euros then one pip would equal 5.5555 Euros, as:
(0.0001/1.8000) x 100,000 = 5.5555
Do pips affect your trades if you are hedging?
Many investors believe that they are in a risk-free position because they are hedged. Hedging is a risk-taking position because a widening spread affects your positions. When an important economic event occurs the gap between the bid and the spread can widen by more than 100 pips usually in the case of highly liquid currency pairs. If an investor is hedging a pair that's less liquid, the spread can be even more disastrous and result in a huge loss to a hedged trader.
Concluding remarks: Understanding the change in value helps traders to enter, or modify orders to manage their trading strategy. The value of one pip can have sharply different values depending on the currency pair and pricing convention. While the difference may look negligible, in the multi-trillion dollars per day foreign exchange market, this quickly turns into a large figure.
