Understanding Forex Pips and Lots
Before you can even begin to trade or analyze the forex market, you need to have a solid grasp on pips and lots. Although they are among the important facets of currency trading, a lot of traders are not even familiar with how they work.
It is true that forex pip calculation is done by your broker or a computer program, but as it is the process by which your profits or losses are determined, it is vital that you get a handle on the procedure, just as it is important that you know the real issues at hand instead of just leaving everything to your broker.
The pip is the term used to denote the movement of a currency. For instance, if the USD/JPY, currently at 120.70, moves up to 120.71, it has moved up by one pip. As the pip value goes up or down, you will be able to determine your currency's performance in the forex.
To calculate pips, you have to first take into account the currency pair you are holding. If the U.S. Dollar is the base currency, then you take the one pip and use it to divide the current rate. For instance, in the USD/JPY example, 1 pip is equal to .01 (most currencies have four decimal places, .0001, but with the Yen it is just two) and use it to divide 120.70.
For other forex currencies, the divisor is usually .0001, but otherwise the process is the same. For currency pairs wherein the USD is not the base currency, such as the GBP/USD, the process involves dividing the current rate by .0001 and multiplying the answer by the exchange rate of the pair.
Since the values we are speaking constitute fractions of a cent, one has to buy and sell at larger amounts in order to realize a profit, so the forex trades in lots. The standard lot size in a typical account is $100,000, but there are also smaller $10,000 lots.
In order to determine your profitability, assume that you are trading with a $100,000 lot. You begin by using the process described before to evaluate the value of a pip (dividing the exchange rate by .01 or .0001) and multiplying the answer by your lot size (in this example that would be $100,000).
With that in mind, you are now able to calculate, based on the fluctuation of the forex, how your currency is moving up or down in value. Whether you decide to buy and sell, remember that you are subject to the spread and that should always be taken into consideration.
As stated, all the numbers are performed by software or your broker, but having a firm understanding of how currency prices move in the forex will give you more insight into the workings of the market. This will not just increase your knowledge but also help you in making the right decisions.