Written by Robert McKinley

Forex Math

Let's talk about Pips again

We gave a brief description of pips in How It All Works. Now, we'll go into more detail about what they are and how profit and loss is calculated using them.

Pip Basics

1. A Pip is the smallest increment in any currency pair rate. Since a pip is the smallest increment in a rate quote, it is represented at the last digit to the right of the decimal point. For example, in the currency rate EUR/USD = 1.3904 the last digit on the right is what you will use to calculate pips. If the currency rate has only two decimal places like the USD/JPY pair (USD/JPY = 119.56) the last decimal place is still a Pip.
2. Pips are used to calculate profit and loss in FOREX transactions. For example, if you buy when the rate is EUR/USD = 1.3901 and sell when the rate is 1.3906, you earned 5 pips on the trade. (1.3906 - 1.3901 = .0005 or 5 pips)

How to Calculate Pip Values (If you really want to.)

The math in this part gets just a little tiresome but there is good news: You really don't need to do these calculations yourself because most FOREX brokers do it for you, automatically. Still, the formula is offered here in case you just want to know how to do it.

So just how much in dollars is the movement of one or more pips worth—for example, per 10,000 Euros in EURUSD? How much is one pip worth per 10,000 Dollars in USDJPY? To demonstrate, we will refer to 10,000 units of the base currency, as the "Notional Amount."

The formula for calculating a pip value is:

(One pip, (with proper decimal placement)/currency exchange rate) x (Notional Amount)

Example with USDJPY: (.01/130.46) x USD10,000 = $0.77 or 77 cents per pip

Example with EURUSD: (.0001/.8942) x EUR10,000 = EUR 1.1183

Now, in the EUR/USD example, we want the pip value in USD, so we must multiply EUR1.1183 x (EURUSD exchange rate): EUR 1.1183 x .8942 = $1.00

This is a phenomenon you will see with any currency where the currency is quoted first (such as EUR/USD, GBP/USP, or AUD/USD): the pip value is always $1.00 per 10,000 currency units. This is why pip (or "tick") values in currency futures, where the currency is quoted first, are always fixed.

Approximate pip values for the major currencies are as follows:

(per 10,000 units of the base currency)

USD/JPY: 1 pip = $.77. A change from 130.45 to 130.46 (1 pip) is worth about $.77 per $10,000.

EUR/USD: 1 pip = $1.00 (.8941 to .8942 is worth $1.00 per 10,000 Euros.)

GBP/USD: 1 pip = $1.00 (1.4765 to 1.4766 is worth $1.00 per 10,000 Pounds.)

USD/CHF: 1 pip = $.59 (1.6855 to 1.6866 is worth $.59 per $10,000.)

At this point, you may be thinking that 1 pip multiplied by 10,000 units of a currency doesn't add up to much money and that you will need a lot of capital to become a viable trader! Not to worry; just keep reading.

Lots, Margin Accounts & Leverage!

We also covered "lots" and "margin accounts" in How It All Works but we will expand these topics now to show you why trading in lots is so important and how trading in lots with leverage makes it possible to earn high profits.

Remember these four things:

1. Currencies are measured in pips, which is the smallest increment of a currency exchange rate.
2. Spot FOREX is traded in lots.
3. The size of a standard lot is US$100,000 and the size of a mini lot is US$10,000.
4. Margin accounts give traders tremendous leverage.

To take advantage of the small monetary increments represented by pips, a trader must trade large amounts of a currency in order to realize any significant profit potential. This is where leverage comes in. Remember that in FOREX traders can trade large amounts of currency with relatively small amounts of capital by using the leverage they have with their margin accounts.

First, calculate pip values:

For these examples, we will use a $100,000 lot size.

USD/JPY at an exchange rate of 119.90 (.01 / 119.80) x $100,000 = $8.34 per pip)

USD/CHF at an exchange rate of 1.4555 (.0001 / 1.4555) x $100,000 = $6.87 per pip)

When the US Dollar is not quoted first, the formula is different.

EUR/USD at an exchange rate of 1.1930 (.0001 / 1.1930) X EUR 100,000 = EUR 8.38 x 1.1930 = $9.99734 rounded up will be $10 per pip)

GBP/USD at an exchange rate or 1.8040 (.0001 / 1.8040) x GBP 100,000 = 5.54 x 1.8040 = 9.99416 rounded up will be $10 per pip.)

Calculating profit and loss

In this example, you will buy US dollars and Sell Swiss Francs

1. The rate you are quoted is USD/CHF 1.4525 / 1.4530 (The first part of the quote is the bid price and the second part is the ask price.)
2. Because you are buying US you will buy at the ask rate of 1.4530, which is the rate at which traders are prepared to sell.
3. You buy 1 lot of $100,000 at 1.4530.
4. Later, the price appreciates to 1.4550 and you decide to close your trade.
5. The new quote for USD/CHF is 1.4550 / 14555. You initially bought the pair to enter the trade, but now since you are closing the trade you must sell the pair at the bid price of 1.4550 (The price at which traders are prepared to buy.)
6. Since the difference between 1.4530 and 1.4550 is .0020 (20 pips), using our formula from before, we now have (.0001/1.4550) x $100,000 = $6.87 per pip x 20 pips = $137.40. You have earned a profit of US$137.40.

More about leverage and margin accounts

You get leverage when you open a margin account. The topic of margin accounts is sometimes controversial because using too much margin can be very risky. However, it all depends on the individual trader. The important thing is to make sure you understand your broker's margin account policies so you can correctly assess the risk.

Leverage gives small investors and large investors, alike, the ability to trade large amounts of money with small amounts of money. For example, if you choose to trade with a 1% margin account, you will be able to trade $100,000 in currencies with a $1,000 deposit. This is how leverage works in the FOREX market.

As you will learn later when you look at different brokers, the amount of leverage available to you depends on the policies of the brokers. Brokers require a minimum account size, which is also known as account margin or initial margin. They also specify how much is required per position (lot) traded. The minimum security (margin) for each lot may also vary from broker to broker.

Margin Call

If the money in your account falls below margin requirements ( also called "usable margin"), your broker will close some or all of your open positions. This prevents your account from falling into a negative balance. It is a safety mechanism.

Example 1

You open a FOREX account with $2,000. You then initiate a 1 lot trade of the EUR/USD pair, which has a margin requirement of $1000. "Usable Margin" is the money available to open new positions or sustain trading losses. In this case, since you started with $2,000, your usable margin is $2,000. But when you opened the 1 lot trade with a margin requirement of $1,000, your usable margin changed; It is now $1,000 ($2,000 - $1,000 = $1,000).

In this example, if your losses exceed your usable margin of $1,000 you will get a margin call.

Example 2

You open a FOREX account with $10,000. You then initiate a 1 lot trade of the EUR/USD pair, which (again) has a margin requirement of $1000. Remember, usable margin is the money you have available to open new positions or sustain trading losses. So prior to opening the 1 lot trade, you had a usable margin of $10,000. After you open the trade, you have a $9,000 usable margin and $1,000 of used margin.

In this case, you will not get a margin call unless your losses exceed your usable margin of $9,000.

If because of trading losses, the equity (the value of your account) falls below your usable margin, you will either have to deposit more money or your broker will close your position to limit both your and his. Therefore, you can never lose more than you deposit. Again, it is a safety mechanism.

IMPORTANT: Be sure you know the difference between usable margin and used margin. Also, learn what your broker's margin account policies are before you open one.

• Leverage = 100 / Margin Percent
• Margin Percent = 100 / Leverage

Now, you know how you can use relatively small amounts of capital to buy and sell relatively large amounts of currencies. It's all about leverage!