What is a Pip and Lot in Trading?

The terminology used by market participants that engage in forex trading can be confusion, as there are many ways that forex traders describe how a currency pair moves, along with the size of the position. The smallest increment that is used to describe a change in an exchange rate is a pip. A pip, which stands for “point in percentage” is similar in all currency pairs except the yen. In general, U.S. dollar related currency pairs are 1-basis point which is 1/100 of 1%, which is the same at 1/10,000. When you start to trade the forex markets, you will be trading lots, and based on the forex broker you decide to use, the lot size can be somewhat different.

The most liquid currency pair, is the EUR/USD. The exchange rate that is most commonly quoted tells you the number of US dollars needed to purchase 1-Euro.  For example, if you see a quote on the EUR/USD that is 1.3015, the rate tells you that to purchase 1-Euro, you would need 1.3015 US dollars.

The quote of the exchange rate on the EUR/USD goes out 4-decision places, which makes it the 5 in the prior exchange. The increment is 0.001, which is the size of a pip. If the rate increased by 1-pip it would climb to 1.3016, and if the rate declined by 1-pip, it would fall to 1.3014.

Fractional Pips

The liquidity in the forex market is excellent and in many cases currency pair can be quoted down to a fraction of a pip. Generally the smallest precision is 1/10 of a pip. This fraction, allows market makers to reduce spreads, especially when liquidity is robust. This is a benefit to the market taker as the spread is part of your transaction cost and therefore a component of your profit and loss. If you see a quote of 1.30151, you can assume that the broker that you are using has reduce the spread into tenths of a pip, designated by the 1 that follows the 5.

How to Calculate the Value of a Pip?

The value of 1-pip, or in the case of the EUR/USD is 1/10 of 1-basis point, which is relatively small if you are exchanging small increments of currency, but as the volume increases, a pip can become significant. Since the leverage provided by forex brokers in the currency markets can be substantial, a pip here and there can add up.

For example, let’s say that you were placing a 10,000 Euro trade versus the US dollar. Using the example of 1.3015, you would need to pony up $13,015 (10,000 * 1.3015).  If the currency pair increases by 1 pip, the price that you would need to pay is $13,016 (10,000 * 1.3016). What this tells you is that if you increase your volume by 10,000 Euros, the cost of a pip increases by $1. So on a million Euro trade, 1-pip would equal $100. Though a 1-million Euro trade sounds large, if your broker provides leverage of 100:1, this size trade would only require equity capital of 10,000 Euro.

As we discussed, the value of a pip is different for the Japanese yen. For example, a pip on a quote of the USD/JPY 110.52, is 1/100^th as opposed to 1-ten-thousandth.  For the USD/JPY which is the most liquid of the yen denominated currency pairs, a pip is 2-decimal places to the right. So an increase to 110.53, would describe a 1-pip increase and a decline to 110.51 would reflect a one pip drop.

The value of a pip for a USD/JPY trade would be a follows. If you decided to purchase $10,000 of USD/JPY for 110.52, it would cost you 1,105,200 yen. A 1-pip increase to 110.53, would make the cost 1,105,300 yen, which is 100 yen more. This is equivalent to $0.905, which is approximately the same cost that you would experience using the EUR/USD which on 10,000 euros is $1.

What is a Lot in Trading?

A lot describe the volume of the base currency that is traded. Within the forex space, there are 4-different lot sizes, not counting futures lots.

A standard lot is 100,000 of the base currency. So, if you want to trade the EUR/USD the standard lot size is 100,000 Euro. On a USD/JPY trade, the base currency is the US dollar, so a standard lot would be $100,000.

Many brokers provide what is referred to as a mini-lot. This is defined as 10,000 units of the base currency.

Additionally, your forex broker might offer micro-lots. This is defined at 1,000 units of the base currency.

Lastly, some brokers offer nano lots. A nano lot is 100 units of the base currency.

The difference can be significant. Where the value of a pips on a standard lot of EUR/USD is $10, it is only $0.10 on a micro lot.

In addition to the 4-different types of lot sizes available at many forex brokers, there are also futures contracts on currencies. The Chicago Mercantile Exchange, provides a wide array of futures contracts, with differing lot sizes. For example, the EUR/USD standard contract is 125,000 Euro, while the mini lot size on that same currency pair is 1/10^th of that size. There is more than 100 billion in liquidity in the futures market, which makes this one of the most attractive places to transact. The lot size for the USD/JPY is 12,500 yen, the British Pound is 100,000 pounds, and the Australian dollar lot size is 100,000 Australian dollars. The minimum price increment, which is called a tick, is very similar to a pip. For example the tick on the EUR/USD futures contract is 0.001.

What is Leverage?

The volatility in the forex markets is relatively tame relative to stocks, or commodities. Historical volatility in certain stocks and commodities can consistently climb above 30%, where it is unusual for volatility in the forex markets to climb above 15%. To allow traders to generate robust returns, leverage has been created by forex brokers which allow you to borrow capital to invest in the currency market.

Most brokers offer margin which allows you to borrow capital using the currency pair you purchased or sold as collateral. Margin provides leverage, which can enhance and detracted from returns.

Margin Defined

Margin is considered collateral that you deposit into your account to cover any losses you might experience when trading a currency pair. Margin is most often associated with a broker or an exchange. The collateral that can be used to post margin can be in the form of cash or in some cases treasury securities.

Initial margin, is an amount of capital that is needed to be deposited for a trade to be executed. Once you transact a currency trade, your margin account is monitored to insure there is enough capital in an account to cover any loses that might incur on a position. This initial margin is to be paid no matter if you are the long or the short in this new position.

There is a second type of margin which is known as Maintenance Margin. This is the amount of money an investor must maintain in his or her account to keep an open position. Should the value of the investor’s account fall below the maintenance margin, his or her brokerage will issue a margin call.

A margin call is the broker’s requirement for additional capital to make a loan whole. If unrealized losses incur that are above the level of collateral held on deposit by the broker, the investor will need to add the required capital to satisfy their debt.

Leverage

A margin trade creates leverage or gearing for an investor which can enhance or detract from the returns of a portfolio. For example, you open an account with $2,000. You decide you want to purchase the EUR/USD, and you plan on using $1,000 of your portfolio. Your broker offers you leverage on 1-standard lot, of 1%, which is 100 to 1. This means to trading 1-lot, you need to post initial margin of 1,000 euros (100,000 * 1%).

Let’s say you purchase the EUR/USD at 1.1250 and the currency pair moves your way and you take profit at 1.1280. Your profits are calculated as following. You bought 10,000 Euros for (10,000 * 1.1250) $12,500, and you sold the 10,000 for $12,800 (10,000 * 1.1280), generating a gross profit of $300.

Margin and leveraging are important concepts to understand especially before you risk capital with borrowed funds.

You need to be careful not to bet more than you can afford. If instead of the EUR/USD moving up to 1.1280, it moved down to 1.1150, you would experience an unrealized loss. You bought 10,000 Euros for (10,000 * 1.1250) $12,500, and the current exchange rate at 1.1150 would make the value of the transaction = 10,000 for $11,500 (10,000 * 1.1150), generating a gross unrealized loss of $1,000. At this point, your portfolio would be down 50%, and your broker might ask you to increase your account size or unwind your position. If the exchange rate declined their equity limit, which would be close to 1.1050, your broker might require and immediate deposit or they will liquidate the position for you, as to avoid having a loss that is greater than your equity.

What is a Bid Ask Spread?

When you transact a currency transaction, you generally do not pay commission. This is because market makers generate their revenue from creating a bid ask spread. The bid price describes where market makers are willing to purchase a currency pair, while the offer price is where market makers are willing to sell a currency pair.

So, if you want to purchase a currency pair from a market maker at the market, you will buy on the offer, and if you want to sell a currency pair from a market maker at the market, you will sell on the bid. You will normally see a quote that shows the bid offer spread. For example, 1.1210/12. This would reflect a 2-pip bid offer spread, were a market maker will buy at 1.1210 and sell at 1.1212. The tighter the bid ask spread, the more liquid the market is at the present.

Tips from the Expert

• A pip or point in percentage is approximately 1/10,000 in the change in a current pair. In theory it’s the smallest move but, in the current trading environment there are fractional pips, which help drive liquidity.
• All pips on major currency pairs and major crosses are located 4 places to the right of the decimal except for yen currency pairs which is 2-places to the right of the decimal.
• A fractional pip is a percent of a pip.
• A lot is a standard volume that is traded in the forex markets. The standard lot is 100,000 units of the base currency.
• Leverage is borrowed capital that allow you to enhance your returns. Be careful with how much leverage you use.
• The bid offer spread describes the liquidity in the market place. The bid is where a market maker will purchase a currency pair, the offer is where a market maker will sell a currency pair.