Understand Forex Terminology
Welcome news to anyone considering starting a Foreign Exchange Currency Market (FOREX) business is the knowledge that trading currency online is very similar to many day-to-day activities, such as paying money for goods and services or trading your time in exchange for money.
The same skills that allow you to find an item you wish to purchase at the best possible price and to maximize what your time is worth to an employer, customers or clients are the same skills involved in trading currencies.
Not necessarily as welcome, however, is the news that you will have to learn some new jargon in order to join the forex market with a reasonable expectation of understanding what exactly is taking place.
One example of this jargon is a seemingly harmless three letter word: pip.
You will likely encounter such phrases as, “The EUR/USD didn’t even move 50 pips today,” or, “If the GBP/AUD had been able to go up 20 pips, key resistance would have been broken.”
So, what is a pip?
It is simply the smallest amount by which the price of a currency pair can change and have an effect on the value of a trade.
To understand this better, take a look at this EUR/USD quote: 1.33895. All this means that in order to purchase one euro using the U.S. dollar, you will have to pay $1.33895.
But wait, the smallest unit of United States currency is the penny, so how can you pay $1.33895? Shouldn’t one euro cost $1.33?
The answer lies in the fact that many currency transactions are so large that more decimal places are required. It is the fourth decimal place, in this case the 9 that equals one pip in value. The fifth decimal place is known as a micro pip. For most individual traders, those that are not trading millions of currency units, the micro pip has little significance. In fact, many trading platforms offer the ability to have price quotes displayed without including micro pips. This would make the quote 1.3389.
It is the fourth decimal place that represents the pip. In the above example, if the value of the U.S. dollar declined by one pip, the quote would now be 1.3390. If the dollar went up one pip, the quote would read 1.3388. It seems mildly confusing at first, but it becomes quite natural in short order, especially when a demo account is used to observe the effect of a one pip price change on the practice account balance.
For practical purposes, each 100 units of the EUR/USD changing value by one pip would equal $0.01 of U.S. currency. If a trader had purchased 10,000 units of the EUR/USD thinking that the value of the euro compared to the dollar would increase, each pip would represent $1.00 in value. If the quote were to change up one pip from 1.3389 to 1.3390, the trade would be profitable by $1.00. If the quote decreased one pip to 1.3388, the trade would be losing $1.00.
Now, to put this in context, if you were to purchase 10,000 units of the EUR/USD and at the end of the day found yourself thinking or saying, “The EUR/USD moved less than 50 pips today,” a winning trade would add less than $50 to your account balance and a losing trade would have reduced your balance by less than $50.
Correlating this small change in price activity to everyday life, it would be similar to seeing an item you had been considering purchasing go on sale for ten percent less that its usual price, and deciding that this decrease was not sufficient to prompt you to make the purchase when you knew that waiting might produce a twenty percent discount.
To summarise, forex trading is very similar to everyday life. It will require one to spend some time becoming familiar with the unique terminology, but understanding terms such as pip is really just a matter of spending some time availing yourself of the glossaries and other educational resources that forex brokers make available to their clients.