In the previous lesson we explored pips and analysed their returns using practical examples. In this lesson, we’ll see how important it is to take into account the value of the pip for each currency pair when calculating its value. In fact, as we just mentioned at the end of the Lesson 10, the value of the pip changes per pair (for example in the EUR/USD it is 10 while in the EUR/GBP it is 17). The value of the pip is important because it is used to calculate the broker’s spread, the trader’s profits and losses, and the stop limit/loss.
Pips and Spread
We’ve previously learned that a broker’s earnings don’t depend on whether we win or lose. A broker earns when we place a purchase or sale order, or when we open an up or down position. However, there are transaction costs on the real stock exchange. The broker’s profit is calculated from the difference between bid and ask, called the spread. For example, if the EUR/USD cross is quoted at 1.300/1.302, the spread will be 2 pips. In practice, for every open position on that pair the broker will earn a value of the pip multiplied by 2. For example: for a lot of EUR/USD, if the pip is equal to 10 (as we have seen) the broker’s profit will be 20 (2 pips x 10).
Pips in the calculation of profits/losses
In Lesson 10 we gave you an example of how to calculate profits based on variations of the pip in the value of the currency pair. However, we did not specify what happens with the spread. Let’s say we have capital of 5,000 and a margin of 600. If there’s a change in our favour of 4 pips, we will have to consider the value of the spread, hence the account of the available capital will be given as 5,000 – 600 + 40 (4 pips) – 20 ( spread) = 4,600. If we close the operation at that time, we’ll re-establish the 600 to guarantee 5,200 of available capital.
Pips to plan stop limit and stop loss
Knowing how much a rising or falling pip is worth is very important in understanding how much you can gain or lose from an operation. For example, if we want to open a purchase position on a pair because we believe that this will get an increased pip, we know that it will be equal to 10 in the case of EUR/USD or only 8 for the USD/JPY. If in the first case the gain is 100, in the second case it’s 80. This is not an unimportant detail. So if we want to set a stop limit and stop loss we will have to remember this difference, because if we want to reach a profit target expressed in euro (e.g., I want to earn 1,000 euro), we will have to calculate it based on the pips of the pair you trade.
Go to the next lesson – Example of Forex Trading