The nomenclature that is used in Forex trading can describe important features of transactions. Two of the most common words that are used to describe the movement of Forex pairs as well as position size is a “pip” and a “lot”. These important terms tell you the minimum movement of a currency pair exchange rate as well as the volume of a trade. They will also help you determine the liquidity of the exchange rate as well as the cost of each transaction. Before you begin to trade Forex, you should understand what a pip and a lot are and how they impact your trading strategies and risk management.
What is a Pip?
An exchange rate of a currency pair will ebb and flow every day, moving up and down. Each increment that and exchange rate moves is called a point in percentage, or a pip. For most currency pairs, the smallest movements are one-hundredth of a percent (0.0001). For example, when trading the EUR/USD which is the most liquid currency pair traded globally, a pip in the exchange rate would be the movement from 1.2001, to 1.2002. This exchange rate tells you how many US dollars are needed to purchase 1-Euro.
What is a Fractional Pip
The Forex market is the most liquid of the capital markets, with more than 5-trillion in notional value traded every day. In several cases, the liquidity is so strong that market makers will quote fractional pips. A fraction pip is a portion of a pip. For example, if a pip is 1/10,000 you might get a quote where you can trade half that level. So, if a pip on the EUR/USD is 1.2001/1.2002 (the one or the two), you could see a quote with a fractional pip of 1.2001/1.20015. The benefit of robust liquidity and fractional pips is that it goes directly to your bottom line. The smaller the pip, the lower the transaction cost to the trader.
What is the Value of a Pip?
The value of a pip goes directly to your bottom line. As you can imagine, 1/10 of a basis point has a very small value but as your trade size increases, the value will increase at the same time. If you are trading a very large volume, the value of a pip can become significant. The pip values offered by Rakuten Securities Australia are some of the most competitive and can add up to significant savings. For example, say you are placing a trade for 100,000 Euro versus the greenback. If we use the exchange rate of 1.2001, the value of the currency pair is 100,000 * 1.2001 or 120,010 Euros. In this case, one pip equals 10-euros. If you are a market maker and are trading this value all-day, you could notch up significant costs for each pip you lose. If you are making one million Euro trades the value of a pip could be 100-euros. While a one million Euro trade might seem very significant, with leverage of 100-1 offered by Rakuten Securities Australia, that would equate to a posting-margin of 10,000. Remember the value of a pip will be different for each currency pair. For example, a pip in USD/JPY is 1/100th as opposed to 1/10,000. So, if you decided to trade USD 1,000/JPY when the currency pair is trading 104.01, the value of a pip is (104.01 * 1,000 = 10,401) $1.
What is a Lot?
A lot is the quantity of trade. A standard lot size is 100,000 of a currency pair. If you are planning to trade a EUR/USD position that is 100,000, you would trade 1-lot. Rakuten Securities Australia offers minimum volumes of 0.01 of a lot. Brokers will provide their clients with several different lot sizes. When you multiply the size of a lot by the pips, you can determine the value of a pip. For example, a standard lot of 100,000 Euro multiplied by .0001, equals 10-euros.
How Does a Pip Work Within a Bid/Offer Spread
Currency transactions are generated through a broker or market maker. When you trade a currency pair you generally do not pay commission. Instead, your broker will offer you a price at which they are willing to purchase the currency pair, which is known as the bid, or a price where they will sell you a currency pair, known as the offer. The differences between the bid and the offer are the bid/offer spread. In theory, if your broker can buy on the bid and sell on the offer, they will make money over time. The tighter the bid/offer spread, the more money you will save when you transact with your broker. There will be times when the bid-offer spread could be wider than a pip, especially during volatile market conditions. Additionally, if you are trading less liquid currency pairs or emerging currency pairs, the bid/offer spread could widen.
The Bottom Line
The terms pip and lot are part of the common nomenclature used to define the minimum movement of a currency pair and the volume of a transaction. A pip is a point in percentage and is a one-in-ten thousand change in the exchange rate of a currency pair. This is in theory the smallest movement, but many brokers offer fractional pips, which helps increase the liquidity in the marketplace. A fractional pip is a percentage of a pip. All pips of the major currency pairs are located 4-places to the right of the decimal, except when discussing the yen. A lot is the volume of the trade. A standard lot is 100,000 units of a currency. Rakuten Securities Australia offers several different lot sizes down to 0.01 of a lot. When you multiply the lot by the pips you get the value of a pip. When you multiply the lot by the value of the currency pair, you get the notional value of the currency pair transaction.