"Understanding what is a pip in forex forms the very basic of understanding how prices move in the forex markets. Depending on the type of the financial market that you trade, every market instrument has its own unit of change. With the forex or the currency markets, pips are the smallest units of change that you will see. Based on pips you can calculate the profits that you can make. In this article, we give you the lowdown on what is a pip in forex and how it is important that you understand this small change in the forex currency price quotations. We will also dig a bit deeper and explain to you how the pipette, which is another small unit, smaller than the pip works. By the end of this article, you should have a good understanding of how the forex markets move and how you can use this to understand whether your trade is in profit or a loss."
Before we begin to explain what a pip in forex means, let’s look at some examples. If you are to buy some vegetables, how would you measure your purchase? It is quite likely that you will use the measure of weight.
Therefore, you would buy probably half a kilo of apples. In other words, that would be 500 grams. Of course, you could also measure apples by the dozen, giving it a numerical value. Now let’s say you were to buy a bottle of Coca cola. The most common forms would be a 2 liter cola, a 1.5 liter cola or even a 500 ml bottle.
The liters and grams are nothing but units to measure weight of a solid and a liquid object. Now consider how would you measure a currency?
You measure a currency by means of what is called as a pip. A pip is the smallest unit of change in a currency pair. Currency pairs, for trading are quoted in four decimals. This is quite different compared to when you exchange actual currency for example.
When you head to a foreign exchange transaction stall, the smallest unit that you will be quoted in, is cents. Everyone knows that 100 cents make up 1 full unit of the currency. For example, 100 cents in U.S. dollars is equal to one U.S. dollar.
Because currencies don’t move in cents, they are subclassified into pips. The currency pair, which is quoted in four decimals changes the very least by one pip. This is also known as 0.0001 unit of change.
To give this some perspective, a 1000 pip change is equal to 1 cent change in the currency’s price.
The concept of fractional pricing
Now if you that the pip was the smallest unit of change, think again. There is something smaller than a pip called a pipette. The pipette is used mostly in fractional pricing of the currency pair. This is as deep as forex price can go to.
You might get the term confused for a scientific apparatus. But in the forex world, strangely, the pipette refers to the minute change in the price of a currency pair.
The pipette is basically the fifth decimal in the currency pair. These are often quoted in small letters when you look at a forex broker’s currency quote board. With the fractional pip pricing, forex brokers tend to reduce their spreads even further.
With fractional pricing, what you see is what you get. To understand the benefits of fractional pricing, let’s take an example. Let’s say that the bid price is 1.12001 and the ask price is 1.12005. This means that the actual spread you will be paying 0.04.
In the absence of fractional pricing you would end up paying 1 pip, that is 0.6 pipettes higher than a regular pip.
We should note that while a pip is the fourth decimal of a currency pair, with the currencies that use the JPY as their quote currency, the pip is the second decimal. Whereas, the pipette in these cases is the third decimal change.
Pipettes are widely used mostly for trading, but when a currency pair is quoted, it is usually done only up to the fourth decimal.
What is the value of a pip?
Because pip is the smallest unit of change, the value of a pip can change, depending on the quantity of the currency pair that you want to buy or sell. The quantities that you use to buy or sell are quantified in what is known as a lot. We will explain the concept of a forex lot in the next section of this chapter.
Basically, the higher amount you buy, the higher the value of a pip becomes. Likewise, the smaller quantity that you buy, the lower is the value for the pip.
Within these parameters, the smallest value of a pip is $0.01 or about one cent. And this occurs due to leverage, which is another concept that we will cover in detail in the next sections of this chapter.
So, to summarize, a pip in forex is basically the smallest unit of change in a currency pair. It is represented to the fourth decimal when a currency is quoted. But when it comes to trading, you will come across forex brokers using a fifth decimal pricing.
This fifth decimal pricing brings the smallest unit of change to a pipette. A pipette is widely used for trading rather than anything else. Thus when you quote a currency pair, only pips are used but when trading, you can see the fifth decimal or the pipette being quoted.