Understanding Pips the Building Blocks of Forex Trading

By: Swarnalata

Published on: Mar 08, 2025

Forex trading, also known as foreign exchange trading, is the act of buying and selling currencies to make a profit. It’s one of the largest and most liquid financial markets in the world, with trillions of dollars traded daily. For those new to forex trading, understanding the terminology is crucial, and one of the most fundamental concepts to grasp is the concept of pips.

In this blog post, we’ll explore what pips are, why they matter, and how they impact your trading decisions.

What Is a Pip?

The term pip stands for "Percentage in Point" or "Price Interest Point." It is the smallest unit of measurement in forex trading, representing the smallest price movement a currency pair can make. Most currency pairs are quoted to four decimal places, and a pip is typically the fourth decimal place. For example, if the EUR/USD pair moves from 1.1050 to 1.1051, that’s a one-pip movement.

However, there’s an exception to this rule. When trading pairs involving the Japanese Yen (JPY), a pip is the second decimal place because the Yen is quoted with only two decimal places. For example, if the USD/JPY pair moves from 110.25 to 110.26, that’s a one-pip movement.

Why Are Pips Important?

Pips are essential in forex trading for several reasons:

1. Measuring Price Movements: Pips allow traders to quantify how much a currency pair has moved. This is crucial for analyzing market trends and making informed trading decisions.


2. Calculating Profits and Losses: Pips are used to determine the profit or loss of a trade. By knowing the value of a pip, traders can calculate their potential gains or losses before entering a trade.


3. Risk Management: Understanding pips helps traders manage risk effectively. By setting stop-loss and take-profit levels in pips, traders can control how much they are willing to risk on each trade.


4. Standardization: Pips provide a standardized way to measure price movements across different currency pairs, making it easier to compare performance.

How to Calculate the Value of a Pip

The value of a pip depends on three factors:

1. The currency pair being traded.


2. The size of the trade (lot size).


3. The exchange rate of the currency pair.

Here’s a step-by-step guide to calculating pip value:

Step 1: Determine the Lot Size

In forex trading, trades are executed in lots. The standard lot size is 100,000 units of the base currency. However, there are also mini lots (10,000 units), micro lots (1,000 units), and nano lots (100 units).

Step 2: Use the Pip Value Formula

The formula to calculate the pip value is:

$Pip\; Value=(1\; Pip/Exchange\; Rate)\times Lot\; Size$

For example, if you’re trading one standard lot (100,000 units) of EUR/USD and the exchange rate is 1.1050, the pip value would be:

$Pip\; Value=(0.0001/1.1050)\times 100,000=\$9.05$

This means that for every pip the EUR/USD pair moves, your profit or loss changes by $9.05.

Step 3: Adjust for Currency Pair Variations

If the quote currency (the second currency in the pair) is not your account currency, you’ll need to convert the pip value into your account currency using the current exchange rate.

Pipettes: A Smaller Unit of Measurement

In addition to pips, some brokers use pipettes, which are fractional pips. A pipette is one-tenth of a pip and is represented by the fifth decimal place in most currency pairs. For example, if the EUR/USD pair moves from 1.10500 to 1.10501, that’s a one-pipette movement.

Pipettes allow for more precise pricing and are particularly useful for traders who use scalping strategies, where small price movements matter.

How Pips Affect Your Trading Strategy

Understanding pips is crucial for developing a successful trading strategy. Here’s how pips come into play:

1. Setting Stop-Loss and Take-Profit Levels: Traders often set stop-loss and take-profit levels in pips to manage risk. For example, if you’re willing to risk 20 pips on a trade, you’ll set your stop-loss order 20 pips away from your entry price.


2. Calculating Risk-Reward Ratios: By knowing the pip value, traders can calculate the potential reward relative to the risk. For instance, if you risk 20 pips to gain 40 pips, your risk-reward ratio is 1:2.


3. Analyzing Spreads: The spread is the difference between the bid and ask price of a currency pair, measured in pips. A lower spread means lower trading costs, which is beneficial for traders.


4. Position Sizing: Knowing the pip value helps traders determine the appropriate position size based on their risk tolerance and account balance.

Examples of Pip Calculations in Real Trades

Let’s look at two examples to illustrate how pips work in real trading scenarios.

Example 1: Trading EUR/USD

• Currency Pair: EUR/USD


• Lot Size: 1 standard lot (100,000 units)


• Exchange Rate: 1.1050


• Pip Value: $9.05

If the EUR/USD pair moves from 1.1050 to 1.1100, that’s a 50-pip movement. Your profit would be:

$50pips\times \$9.05=\$452.50$

Example 2: Trading USD/JPY

• Currency Pair: USD/JPY


• Lot Size: 1 standard lot (100,000 units)


• Exchange Rate: 110.25


• Pip Value: $9.07

If the USD/JPY pair moves from 110.25 to 110.75, that’s a 50-pip movement. Your profit would be:

$50pips\times \$9.07=\$453.50$

Tips for Using Pips Effectively

1. Use a Pip Calculator: Many trading platforms and online tools offer pip calculators to simplify the process of determining pip value.


2. Monitor Spreads: Always be aware of the spread, as it affects your breakeven point and overall profitability.


3. Practice Risk Management: Use pips to set stop-loss and take-profit levels that align with your risk tolerance.


4. Stay Informed: Keep an eye on economic events and news that can cause significant pip movements in currency pairs.

Conclusion

Pips are the building blocks of forex trading, providing a standardized way to measure price movements, calculate profits and losses, and manage risk. By understanding what pips are and how to calculate their value, you can make more informed trading decisions and develop a strategy that aligns with your financial goals.