What is a Pip and Lot in Trading?

Market participants in Forex can use some confusing terminology, and there are many ways that they use to describe the size of a currency pair’s position, as well as the way in which it moves. A pip is the smallest increment used to describe a change in the exchange rate. “Pip” stands for “Point in percentage.” It is similar in all currency pairs, not including the yen. Overall, the USD-related pairs are one basis point. This is 1/100th of one percent, i.e. 1/10,000th. When you begin trading the forex markets, you engage in lot trading. Based on your broker, lot size can differ.

The EUR/USD is the most liquid of the currency pairs. The most-quotes exchange rate is the one that tells you how many USD are necessary to purchase one Euro. If you see, for example, a quote on the EUR/USD that reads “1.3015,” this means the to buy a euro, you would need to hand over 1.3015 USD.

The exchange rate quote on EUR/USD extends four decision places, making it five in the above exchange. The increment is .001, the size of a pip. Were the rate to increase by one pip, it would extend to 1.3016. If it went down by a pip, it would drop to 1.3014.

Fractional Pips

The forex market’s liquidity is great. In many cases, a currency pair can be down-quoted to a fraction of one pip. The smallest point is one-tenth of a pip, which allows the market to decrease spreads, particularly when there is robust liquidity. The market taker benefits from this, as the spread if part of the transaction cost. The spread is part of your profit and loss. For example, if you see a quote that reads 1.30151, this means that your broker has reduced the spread into tenths of a pip. This reduction is designated by the one that follows the five.

How Can You Calculate the Value of a Pip?

One pip, or in EUR/USD, one tenth of one basis point, is small in terms of exchange of small increments of currency. But when the volume goes up, a pip gains significance. Forex brokers provide leverage in the markets that is substantial. Therefore, pips add up.

Let’s do an example where you place a 10,000 Euro trade against the US dollar. With 1.3015, you would need to hand over $13,015 (10,000 multiplied by 1.3015).  If the pair increases by one pip, you would need to pay $13,016 (10,000 multiplied by 1.3016). So, if you increase your volume by ten thousand Euros, the price of a pip increases by one dollar. So on a trade of a million Euros, one-pip would equal $100. Although a one- million Euro trade sounds enormous, if your broker provides 100:1 leverage, you would only need to pay 10,000 Euros.

As aformentioned, Japanese yen has a different value. For example, a pip on USD/JPY 110.52, is 1/100th, instead of one-ten-thousandth. The USD/JPY is the most liquid of the yen-denominated pairs, and a pip is two decimal places to the right. An increase to 110.53 would be a one-pip increase; a drop to 110.51 would reflect a decline of one pip.

An example of a USD/JPY trade is as follows: if you chose to buy $10,000 of USD/JPY for 110.52, the cost would be 1,105,200 yen. A one-pip increase to 110.53 would be 1,105,300 yen, 100 more yen. This is the same as $0.905, approximately the same cost you could experience using the EUR/USD, which is $1 on 10,000 euros.

What is a Lot in Trading?

A lot is the volume of the base currency being traded. There are four different lot sizes within forex, not including future lots.

A standard lot equals 100,000 of the base currency. Therefore, if you wish to trade the EUR/USD, the lot size is 100,000 Euros. For a USD/JPY trade, the base currency is the USD, so a lot would be $100,000.

Many brokers offer what is called a mini-lot. A mini-lot is 10,000 units of base currency.

Your forex broker might also offer micro-lots, which are 1,000 units of base currency.

Finally, some brokers offer nano-lots, which are 100 units of base currency.

The difference is significant. While the pip value on a standard lot of EUR/USD is $10, on a micro-lot, it is only $0.10.

Added to the four different lot size types available from many forex brokers, futures contracts on currencies also exist. The Chicago Mercantile Exchange is an example of this. It provides a wide selection of futures contracts, with varying lot sizes. For example, the standard EUR/USD contract is 125,000 Euro, and the size of the mini lot on that same pair is 1/10th of the pair’s size. There is over 100 billion in liquidity in the futures market, making it one of the most attractive places in which to conduct transactions.The USD/JPY lot size is 12,500 yen, the British Pound equals 100,000 pounds, and the Australian dollar is 100,000 Australian dollars. The tick, which is the minimum price increment, is similar to a pip. A tick on the EUR/USD futures contract equals 0.001.

What is Leverage?

The volatility in the forex markets is tame when compared to stocks or commodities. Certain stocks’ and commodities’ historical volatility can consistently reach above 30%. By contrast, it is unusual for forex markets’ volatility reach above 15%. In order to allow traders to get robust returns, forex brokers created leverage that lets traders borrow capital for investing in the currency market.

Most brokers provide margin that lets you borrow capital use as collateral the currency pair you bought or sold. Margin gives you leverage, which both enhances and detracts from returns.

Margin Defined

Margin is collateral you deposit into your account to cover losses you might incur while trading a currency pair. Margin is often associated with an exchange or broker. Post-margin collateral can include cash or, in some instances, treasury securities.

Initial margin, is the capital necessary to be deposited to execute a trade. Once you conduct a currency trade, your margin account is monitored to ensure there is enough capital in it to cover losses that you might incur on a your position. Initial margin must be paid, regardless of whether you are long or short in this new position.

Maintenance margin is the second type of margin. Maintenance margin is the amount of money an investor must keep in his account to maintain an open position. If the investor’s account falls below this maintenance margin, his brokerage will issue a margin call, which is the broker’s requirement for additional capital to be deposited to make a loan whole. If unrealized losses occur above the level of collateral held on deposit by the broker, an investor must add the capital required to satisfy his debt.

Leverage

A margin trade generates leverage or gearing for an investor. This can enhance or detract from the returns of his or her portfolio. For example, let’s say you open an account with $2,000. You decide to purchase EUR/USD pairs and plan on using $1,000. Your broker gives you leverage on one-standard lot of 1%, which amounts to 100:1. This means to trade one lot, you need to post an initial margin of 1,000 euros.

If you purchase the EUR/USD at 1.1250, and the pair moves your way, you will make profit at 1.1280. How are these profits calculated? It’s simple: you purchased 10,000 Euros for $12,500 (10,000 x 1.1250) and sold 10,000 for $12,800 (10,000 x 1.1280), which generates a profit of $300.

It is important to understand margin and leveraging before you risk capital with loaned funds.

Be careful never to bet more than what you can afford. If, instead of the EUR/USD increasing to 1.1280, it moved down to 1.1150, you could experience a loss. Your portfolio would decline 50%, and your broker could ask you to unwind your position or increase your account size. If the exchange rate declined the equity limit, which is close to 1.1050, your broker might require an immediate deposit or they’d liquidate your position to avoid incurring a loss greater than your equity.

What is a Bid Ask Spread?

You generally do not pay commission when you make a currency transaction because. market makers generate revenue from a bid ask spread. The bid price is the point at which market makers will purchase a currency pair, and the offer price is where they are willing to sell.

If you want to buy a currency pair at the market from a market maker, you will buy on the offer. If you want to sell, you will sell on the bid. Normally, you will see a quote showing the bid offer spread. For example, 1.1210:12 reflects a two-pip bid offer spread, where a market maker buys at 1.1210 and sells at 1.1212. The tighter a bid ask spread is, the more liquid the market is at the that time.

Expert Tips

• A pip is approximately 1/10,000 the change in a currency pair. Theoretically, it’s the smallest move but, in the current trading ecosystem, there are fractional pips that drive liquidity.
• Pips on major currency pairs and crosses are located 4 places to the right of the decimal. This does not apply to yen currency pairs, which are two places to the right of the decimal point.
• Fractional pips are percentages of pips.
• A lot is a standard volume traded in forex markets. It is 100,000 units of base currency.
• Leverage is borrowed capital that can enhance returns. Be careful with the amount of leverage you use.
• A bid offer spread is the liquidity in the market place. The bid is where market makers purchase currency pairs. The offer is where they sell currency pairs.