Forex Markets: The Basic Units
In currency trading, a pip is short for ‘percentage point.’ Put more simply, a pip is the smallest unit of measure in the movement of a currency’s value. In an analogy to stock markets, a pip would be the equivalent of a penny in the value of Apple stock. Pip values in all currency pairs are not equal, however. This is because not all forex pairs are denominated in the same currency. For example, the GBP/USD forex pair is going to have a slightly different pip value than the GBP/CHF. Spread betting brokers are able to make things easier by assigning pip values that are similar in each forex pair. So, while the pip values in the GBP/USD and GBP/CHF are not exactly the same, they are still very close in value.
When constructing positions, pip values can be extremely useful. Many spread betters will use pip values to determine stop loss levels and profit targets. For example, many day traders will use a certain number of pips in defining risk. A shorter term position might be defined using a stop loss of 40-50 pips, while a longer term position might be defined using a 100-150 pip stop loss (or more).
There are many ways traders can structure potential risk their trades. Some spread betters use percentages when setting the amount of money that is put at risk at any given time (2% of the total account balance is a commonly used standard). But pip values can be useful here, too. So if you wanted to set a risk limit of no more than £500, you could divide by the total number of pips you are willing to risk. Let’s say you have set a 50 pip stop loss on your trade. This would mean that you could use 10:1 leverage for the position. Each pip would be worth £10. In this way, understanding pips values can be highly valuable in the ways you structure your potential profit and loss (P/L).
Another way pip values can be useful is in determining areas where the market is watching a critical psychological level. Let’s say you are trading the EUR/USD, and it is rallying to test 1.30. These ‘big round numbers’ tend to get a lot of attention in the spread betting markets, and traders will often set orders on both sides of these numbers in order to capitalize on the next big trend. For example, spread betters might look to place sell orders just below 1.30 with a stop loss just above the figure. The reason for this is that price breakouts in major psychological price regions tend to be very forceful in nature, so you wouldn’t want to be caught in a sell position if price momentum is starting to accelerate.
Conclusion: Pip Values Are Useful In Defining Position Parameters
Pip values can make it easier for spread betters to visualize the potential risk and reward in a position. If you know that each pip movement is equal to £10 and your maximum risk for a trade is £500, your trade should be structured to close out if prices move 50 pips in the wrong direction. Pip values can also be helpful in defining key psychological regions where spread betters are likely to have collected orders. Knowing about these price regions in advance can help you to set trade orders in areas where markets are likely to move in a more predictable fashion. Capitalizing on this information can help you to increase the odds for success in your spread betting trades.