Pips & Leverage

What are Pips?

Pip is probably one of the most important terms to know when trading in the Forex market. It is simply impossible to fully grasp the meaning of a Forex position/trade without understanding the concept of a pip.
This influences your trading strategy, your calculations for ‘Take Profit’ and ‘Stop Loss’ (which are of great importance for money management of your portfolio) and other factors that require significant consideration such as limits and calculating the desired leverage.
Furthermore, the broker’s profit is calculated by the amount of pips between the buy and sell (Bid & Ask) rates, also known as the spread.
Percentage in Point / Price Interest Point, otherwise known as PIP, represents the smallest movement that a currency pair can make. Most currency pairs, except for the JPY, are priced to four decimal places, meaning that a pip is one unit of the fourth decimal point (0.0001).
* Some brokers also provide the 5th decimal point, the decimal fraction (0.00001, representing 10% of a pip).
  As a member of Pips Bring Friends, Winpips offers you 10% of a pip. 
 

How to calculate the value of a Pip?

As mentioned; pip is a unit representing the value of the movement of the underlying currency pair.
In most Forex trading platforms, the traded amount is measured in “Lots” where one lot equals 100,000 of the base currency, being the left currency of the pair.
On the other hand, while the lots are measured in the base currency, the pips are measured in the quote currency, being the right currency of the pair.

Lot size:

→  0.01 Lot = 1,000 (micro-lot)
→  0.1 Lot = 10,000 (mini-lot)
→  1 Lot = 100,000
→  10 Lots = 1,000,000
→  100 Lots = 10,000,000

Examples for Pips Calculations:

EUR/USD at an exchange rate of 1.1980. Let’s imagine that the rate goes up to 1.1990 (10 pips higher).
»  Taken with 1 Lot: 100,000 (equals 1 lot)  /10,000 (in order to get to pip size 0.0001) = $10.
    1 pip is worth $10, so 10 pips are worth $100.
»  Taken with 0.1 Lot: 10,000/10,000 = $1 per pip, so 10 pips are worth $10 taken with 0.1 lots.
USD/CAD at an exchange rate of 1.2851. Let’s imagine that the rate goes up to 1.2881 (30 pips higher).
»  Taken with 10 Lots: 1,000,000/10,000= 100 CAD (for 1 pip) ⇒ 100 CAD * 30 pips movement = 3000 CAD.
»  In order to get to the value in $: 3000CAD / 1.2881 = $2,329

!! For JPY pairs, the pip size is not the usual fourth decimal point, rather to the 2nd decimal point 1/100 (0.01).
USD/JPY at an exchange rate of 109.27. Let’s imagine that the rate goes down to 109.00 (29 pips lower).
 ⇒  Taken with 1 Lot: 100,000/100 = 1,000 JPY (for 1 pip) ⇒ 1,000 JPY * 29 pips movement = 29,000 JPY / 109.00 = $ 266.
 

Important!

The majority of the day-traders tend to follow their profit amount instead of deciding on a daily target pips.
For example; when you quickly acheive $300 profit during your trading day, the psychology of the trader triggers and you are eager to reach more…
“I already made $300,… why not make it $500?… And if that… Why not make it a $1000?” This is where everything goes wrong and you end up erasing all you day’s work.
When you learn to look at the average daily pips volatility, you get a better concept of how much you should target profiting in pips on each trade, eliminating the greedy psychological dimension.
Think in pips rather than in amounts, and you’ll overcome the psychological sinkhole that is every trader’s downfall.

What is leverage?

Leverage is a financial instrument allowing banks and brokers to offer retailers and institutions the ability to profit significantly more compared to their invested amount.
This amazing tool is used in order to spare huge transactions between banks when you can’t risk/afford more than a certain amount.
Example: Importers and exporters, using Forward deals, usually get a leverage of up to 1:10 from banks, meaning with their $100,000 investment, they can trade with $1,000,000.
The majority of the regulated brokers provide Forex day traders (Spot deals/ same day) with a leverage of 1:100, meaning that with a $10,000 investment, they can trade with $1,000,000.
Let’s show you the advantage of leverage in an example….
Jeff, a day trader from the UK, strongly believes that the GBP should strengthen against the USD, but he can only afford to invest £2,000. His broker offers him to maximize the potential of the trade by taking advantage of the fluctuation of the markets and provides him with a leverage of 1:100, meaning that with his initial £2,000, he can now trade with £200,000.
*  Say that Jeff was right and the GBP strengthened 4%, this means that he made £8,000 (including his £2,000) in profits. Thanks to the leverage, Jeff made a remarkable profit of 400% on his £2,000.
*  In contrary, say that Jeff was wrong, and the GBP weakened by 4%, Jeff risked only £2,000 (investment) being only 1% of the leveraged amount.
To summarize, leverage can be an amazing tool allowing a trader the opportunity to be part of the biggest market in the world with a volume of more than 5 trillion/day.
The profit potential is unlimited while you risk to lose only your initial investment, as was the case when Jeff was wrong (he lost £2,000 = 1% of the leveraged amount).
Leverage has the potential to enlarge your profits or losses by the same magnitude. This means that the greater the applied leverage on your capital is, the higher the risk you are assuming.
WARNING:
  Many non-regulated brokers will try to offer you a leverage higher than 1:100 (1:200 to even 1:400) in their sales pitch to convince that they have the ability to give you “a better” leverage.
→  Know that a leverage of 1:200 means that your Margin is only 0.5%!
→  Know that a leverage of 1:400 means that your Margin is only 0.25%!
→  This means that even the slightest fluctuations in the market that day could burn you in a matter of a few minutes. Therefore, we would not recommend day traders to take a leverage higher than 1:50 (2% Margin).