In Forex, a pip is 1 basis point
which is the lowest price movement of a currency. Each pip represents a profit
or loss point depending on the number of lots traded. A lot is a group of individual
goods bundled together to form a set standard quantity that would form as a
single unit set by exchanges or an institution. In currency trading a lot would
be composed of 10,000 pieces of notes ($10,000) for a mini account, and 100,000
pieces of a unit of currency as a standard ($100,000).
Using a broker to trade currencies
is a lot different than doing the normal buying and selling through a money
changer or a bank. It is more interactive and you can instantaneously react
to major economic events as they unfold across the globe. Unlike stocks or commodities
in which you could only trade during business hours, Forex brokers stays open
since a financial center somewhere on the other side of the world should be
open when it is night time on your current time zone, you could trade whenever
a major significant economic news came out in Japan that would directly affect
Currency brokers provide tight spreads when buying or selling currencies and
would make you think that rates over a money changer are ridiculous. Spread
is the difference between the rate in which you could buy the currency and the
rate where you could sell it. For example at a local bank you could buy the
British Pound at $2.06 per Pound and sell Pounds at $2.00 per Pound. The spread
is 6 cents ($2.06 - $2.00 = $.06) that is about 600 Pips. Currency brokers on
the other hand offers spreads as low as 3 Pips. A pip or basis point is 1/100
of a percent. This is the smallest increment in price movement.
For example, if you trade a single standard lot of EUR/USD the pip value would
be $10. Should the price increased 3 pips, you gained $30 from that move because
each pip costs $10, but when the price dropped 5 pips you lost $50.
The trade shown above is buying Euros and selling US dollars, the standard lot size which is 100,000 is not of the US dollar but of the Euro. You bought 100,000 Euros in this transaction and sold $142,000 USD.
Buying the same amount of Euros at current exchange rate with your US dollars at the bank and selling it at the same pip movement would produce the same profit. Basically we had $142,000 and bought Euros.
($142,000 US dollars / $1.4200 per Euro = 100,000 Euros)
When the rate moved 13 pips, we exchange it back to US dollars.
(100,000 Euros X $1.4213 per Euro = $142,130 US Dollars)
We subtract the principal from our revenue to determine profit.
($142,130 - $142,000 = $130 Profit)