Lesson 6: Pips, Pipettes, Lots and Brokers

Monitoring exchange rates and explaning pips

Monitoring exchange rates and explaning pips[laeconomia.com.mx]

We know that the exchange rates between two currencies constantly fluctuate up and down, depending on a large amount of factors, which govern the actions of forex traders, such as government policies, the activity of trading between two countries, a change in government, or a natural disaster. Some of these, especially the latter two do not happen every day, but the constant trading in goods and services between two nations, or trading blocs (in the case of the Euro zone) cause one currency to weaken or strengthen against the other every second.

We know that these changes happen but how do we read them in order to make a profit and govern our actions in order to buy one currency or sell another?

What is a pip?

A pip is the unit of measurement given for the change in value between two currencies.
Exchange rates are usually expressed with four decimal places. For example:

1 GBP: USD: 1.5000

Pip

A pip is the fourth decimal place given in an exchange rate.
If in one minute’s time the exchange rate between the GBP and the USD changed to:

1 GBP: USD 1.5001

+1 pip

The exchange rate between the two will have gone up by 1 pip.

Pipettes

1 GBP: USD 1.50000

pipette

Sometimes brokers will quote currency pairs up to five decimal places and will quote in fractions of pips, otherwise known as “pipettes.”

Consequently if the exchange rate changed and was quoted as:

1 GBP: USD 1.50001

+1 pipette

A word on the Japanese Yen

The Japanese yen is always expressed only in two decimal places. Therefore any pip change using this currency is 0.1 JPY instead of 000.1 as is with most other currencies. Therefore a pip change using the yen as the quote currency would be expressed like this.

e.g. GBP/JPY = 1: 2.35
a one pip change would be: 1:2.36

Calculating pips

Pips are not real, physical money that you can spend in the shops. In order to do this you must calculate the value of each pip in order to work out how much real money the currency pair have gained or dropped in value against each other.

Using our exchange rates:

1 GBP : 1.5000 USD
1 GBP : 1.5001 USD

We can work out what the value of one pip is by using the following formula:

1 pip = Value of counter exchange
currency change x rate ratio

= 0.0001 x 1GBP/1.5000USD

= $0.00006666

Using this formula we can now calculate how much money you would earn with different values if the exchange rates between currency pairs were to go up by one pip.

If we traded 10 units of GBP/USD then we would have:

= 10 x 0.00006666
1 pip =$ 0.0006 USD

100 units
1 pip =$ 0.00666 USD

1000 units
1 pip = $0.06666 USD

10000 units
1 pip = $0.66 USD

100000 units
1 pip= $6.60 USD

And so on..

Obviously exchange rates will up or down by several pips, but by being able to work out the value of one pip it enables traders to forecast how much profit or loss they would make on a particular trade.

Translating Pips into your own currency

Of course forex traders are spread across the world and have dealt in their home currency since they could talk. There is a simple calculation in which traders can make in order to convert the value of pips into their home currency and have a clearer idea of how much money they have made.

If the value of 1 pip is $0.66USD per 10,000 units then we can convert this into GBP by doing the following calculation:

Pip value x home currency (GBP) /currency which pip value is currently in (USD)

= $0.66 x 1/1.50000

= £0.44

Therefore for one pip movement in the exchange rate between the GBP/USD at an exchange rate of 1:1.5000 is the princely sum of 44p…. enough to buy a Mars bar in Poundland..

The good news

When trading forex you do not have to work out the value of one pip per currency pair. You broker should do this for you; however it is very useful to know the formulae so you know how their quotes are worked out.

Lots

Lots are the amount of currency units you wish to buy or sell. These come in different sizes.

Tables Google Docs

 

 

 

 

As we know the value of one pip is a tiny small percentage of a currency unit, to four decimal places, or five if it is a pipette. There are no coins designed for these tiny amounts. In order to make usable money a trader has to buy and sell currencies in large quantities or lots. The standard lot is 100,000 units.

Therefore using our exchange rate of GBP/USD 1:1.5000 then if we bought 100000 USD then we can calculate how much money per pip we would earn should the exchange rate of the base currency gain in value against the quote currency. The exchange rate changes to GBP/USD 1.1:5001. How much real money would we have made if we put a lot of £100,000 on per pip?

1 pip = pip change/exchange rate x lot

1 pip = 0.0001/1.5000 x 100,000

1 pip = £6.66

Using this method we can now work out the value of one pip change in the exchange rate having placed different amounts of lots.

Tables Google Docs2

 

 

 

 

Therefore if an exchange rate went up by 10 pips over the course of a day then the value of your currency would increase as follows:

Nano- 0.006 x10 = 0.06p
Micro – 0.066 x 10 = 0.66p
Mini – 0.666 x 10 = £6.66
Standard – 6.666 x 10 = £66.66

As you can see, by adding ten pips to the exchange rate because the base currency has gained value against the quote currency the value of each unit has increased. Therefore, the bigger the lot the more amount of money you can potentially make. However, for the complete novice it is essential that you stick to placing nano lots on stable currencies in order to stay safe and limit your losses. Only a complete idiot would place large amounts of money in their first real trades.

A word on brokers

You have probably heard this word used several times during these lessons and I wish to clarify who they are and what they do.

Look upon brokers as like bookmakers in horse-racing. If you wanted to put a bet on a horse called, for example, “Forex Lad” in the Grand National there will be numerous bookmakers who will set their own odds or price on that horse winning the race.

Ladbrokes may offer 5/1 or William Hill 4/1, while bet365 think that “Forex lad is a dead cert to win and give odds of 2/1.

In forex trading, brokers will give you a price for currency pairs.

The bid price is the price in which your broker will buy the base currency in exchange for the quote currency.

The ask price is the price in which your broker is willing to sell the base currency and buy the quote currency

The spread is the difference between the bid and ask price

Therefore: in our example the bid price is

GBP/USD – 1:1.5000

and the ask price is 1:1.5020

Then the spread is: 0.0020

Your broker’s quote says you can buy 1 GBP for $1.50000
You can sell 1 GBP for $1.50020

Quote convention

This is how bid/ask prices are expressed. E.g 1.4560/1.4570 (remember to keep in mind the 1: which is always the base currency (1:1.4560/1:1.4570)
Sometimes the brokers will shorten the bid/ask prices will be quoted just showing the pips/pipettes e.g 60/70 to the more advanced trader. For now we will use quotations in full.

Setting up an account

When setting up an account with your broker there will be two things that need to be agreed. Firstly the margin, which is the initial deposit of money you need to set up the account (a bit like when you set up a savings account.) This can be as low as £100 or £1000 but this depends on individual brokers. Secondly there is what is called leverage.

Leverage

As part of the deal brokers will give you what is called leverage. To make any serious money a trader needs large amounts of cash and unless your daddy owns half of Berkshire, or is the co-founder of Google, not many people have £100,000 lying around.

This is where brokers come in. Like a bank (used to do in the good old pre-2008 days) they will lend you £100,000 in return for a small deposit governed by the ratio.

You and your broker will agree a leverage ratio in order for you to trade (and them to make some money as well.) This depends on the broker and your trading experience.

A 100:1 ratio means that £1 in every 100 is used as a deposit for each trade.

Therefore if you use different amounts of lots at a common ratio such as 100:1 then this how much capital you would have to stump up yourself in the trade.
3Table

 

 

 

 

Consequently if you were to put a standard lot of £100,000 on a trade this is how much you would put in at different ratios

4Table

 

 

 

 

 

Therefore the bigger the ratio, the fewer amounts of money and therefore risk in the trade. Before embarking on forex trading you must make sure that you have a spare amount of capital in order to set up an account with the margin and to negotiate a leverage ratio (the higher the better), with your broker.

Remember the money your broker gives you is “virtual ” and at the end of the trade their money will be wiped away, leaving you with any profit or loss made in the transaction.

To trade, your broker gives you a virtual even £100,000.

Let’s say you trade in GBP/USD and you make a £10 profit in the transaction, then the original £100000 will be deleted from your account leaving you with the ten pound profit.

If you made a £10 loss, then the £100,000 would be wiped away plus the tenner you lost in the trade.

Good, honest brokers of course are essential in forex trading. A list of FXT academy approved brokers can be found here (add link)

Making a trade and how to calculate your profit and loss

Finally.. the most important part..is working out how much wonga you have made in the trade.

So, your broker quotes you the following price for GBP/USD and you buy GBP with USD.

Bid price: 1: 1.4525
Ask Price: 1:1.4530
Spread 0.0005

When buying a currency you use the ask price. This is the price your broker is willing to sell the base currency for – to you!
When selling a currency you use the bid price. This is the price your broker is willing to buy your base currency off you for.

You buy £100,000 units of currency at 1: 1.4530 USD

A few hours later the prices between the two currencies go up to: Your broker quotes you the following prices:

Bid- 1:1.4550
Ask- 1:1.4555

You decide to enter a trade and sell the GBP because it has gained value against the dollar. You use the bid price of 1:14550 because this is the price the broker will buy your base currency off you for.

The difference between the original ask price of the GBP in this trade was 1:14530 and the price which you sold at (or bid price) was 1:1.4550, which is a difference of 20 pips
Therefore: Using our formula before we can work out the value of one pip.

If 1 pip = 0.0001.
= 1 pip / exchange rate x lot = value of one pip
= (0.0001/1.4550) x 100,000 = £6.87
Because the exchange rate went up by 20 pips the amount of profit in this particular trade can be found:
Profit = value one pip x number of pip increase
Profit = £6.87 x 20
Profit = £137.40.
Remember your broker will then take away the virtual £100,000 and leave you with this amount added to your account.

In this transaction this is the amount of money you would have made putting various amounts of lots on this trade.

5Tables

 

 

 

 

 

Not a bad day’s work!

Next lesson: No7. Summary of Forex terms we have learnt so far

Buy our online Course & Support programme (iMarkets Live)

Share this post