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Sunday, 8 January 2017

Pips, Lots, Profit and Loss


Pips, Lots, Profit and Loss

What are the underlying mathematics of it all and how is the value of a Pip determined?

Pips

The Pip is the smallest number to the right of the decimal place. Its value is a function of the exchange rate and lot size, though normally variations in lot size will only move the decimal place.
Since most of you will be trading with US Dollar accounts we’re going to start with pairs where the USD is quoted first, and then move on to the reversed pairs. The basics are the same in both cases, and in fact it’s easier when the USD is not the base currency, as we’ll see.

A simple example:
USD/CAD
In this case we’re trading USD/CAD at an exchange rate of 1.0166. Since the pip is the smallest unit of value that can be measured, it’s 0.0001. This works for all currencies except the JPY where the pip is 0.01. As we’re using the CAD in this example we can stick to the normal 0.0001.
What we do is dividing 0.0001 by the exchange rate to get the pip value. It looks complicated, but what we’re really doing is breaking down the pip to a fraction of USD (or whatever our base currency is).
So, 0.0001 divided by 1.0166 works out to be 0.0000984 which is our pip value in this case.
For those who prefer to see it in mathematical form, here it is again.
USD/CAD = 1.0166
0.0001/1.0166 = 0.0000984

It works exactly the same way with any other currency.
USD/JPY
This one is slightly different, because we use fewer significant figures, but otherwise it’s identical. So this time we’ll trade USD/JPY at an exchange rate of 107.37. As we’re trading the JPY, our pip is based on 0.01.

Plugging it into our formula, we divide 0.01 by 107.37 and get 0.0000931. Again, here it is without the words
USD/JPY = 107.37
0.01/107.37 = 0.0000931
You’ll notice that in both cases we end up with figures of a similar order of magnitude (almost the number of zeroes after the decimal point). That’s because the lower value of the Yen cancels out the greater number of significant figures. If we carried the JPY to the same number of figures as the other currency pairs we’d end up with a much lower pip value so it just makes sense to work it this way.

Let’s take a look at a case where the USD is the quote currency, not the base and see how that works.
EUR/USD
In this case we’re working with the standard 0.0001 pip and an exchange rate of 1.4815. The only difference is because we now have the EUR as the base currency, the exchange is how many US Dollars to the Euro rather than the other currency to the dollar in the previous examples.
So, taking our 0.0001 pip and dividing it by 1.4815 we end up with a pip value of EUR 0.0000675. If we want to get that back to dollars we have to multiply it by the exchange rate, which gives us 0.00010000125 which rounds off to 0.0001.

Again, for those with a preference for seeing it numerically, here it is:
EUR/USD = 1.4815
0.0001/1.4815 = 0.0000675
0.0000675 x 1.4815 = 0.0001

Those of you who have more than a passing familiarity with mathematics will have noticed something about this calculation: It was completely unnecessary. If you are quoting in USD then one pip is always going to be 0.0001. Any time we divide and then multiply by the same number the only changes we’re going to generate are rounding errors.

There is only one time you would need to use this kind of calculation and that’s if neither of the currencies in the pair are the USD and you need to convert it to the USD for your final accounting. In that case you’d divide 0.0001 by the exchange rate between the two currencies, and then multiply by the USD exchange rate. However that’s somewhat beyond the scope of this newsletter so we won’t be covering it here.

Before we go on to turning these very small figures into noticeable amounts of money there is one more thing about figuring pip values that we need to mention: You don’t have to do it.
It’s one of those things that your broker’s software should handle automatically. The reason we include it is because it’s easier to work with things when you understand what’s going on behind the scenes.

Lots

Now let’s move on to LOTS, where we’ll hope to make, and not lose, lots of money. Just as a pip is the smallest unit of value we count in a trade, a lot is the smallest amount of money we use in a trade. For the purposes of this course we’re going to confine ourselves to the “standard” lot which is $100,000 and the “mini” lot which is $10,000.

Seeing how a forex lot works with pips is a simple matter of multiplication. When you multiply the pip value we calculated earlier by the forex lot size you end up with how much each pip is worth.
Let’s start with our first example, USD/CAD at 1.0166. At that exchange rate we have a pip value of 0.0000984. This means that on a lot of $100,000 each pip is going to be worth $9.84. The only catch is that the pip is a moving target. If the exchange rate changes, the pip will change with it. Given that it does change, the question arises as to when do we calculate it?
The answer’s simple: when you take the money out. That’s when pips actually turn to money, so that’s when you figure the value.

Sometimes different brokers may use slightly different conventions for figuring pip values for different forex lot sizes. Don’t worry about it; it’s one of the things your platform calculates automatically. Computers are good at arithmetic, let them handle it.

Here’s a recap:
USD/CAD = 1.0166
Pip = 0.0000984
Standard Lot pip value = 100,000 x 0.0000984 = $9.84
Mini Lot pip value = 10,000 x 0.0000984 = $0.984

USD/JPY = 107.37
Pip = 0.0000931
Standard Lot pip value = 100,000 x 0.0000931 = $9.31
Micro Lot pip value = 10,000 x 0.0000931 = $0.931

For any trade where the USD is the quote currency the pip value is $10 for a standard lot and $1 for a mini lot. It may not look like much, but it adds up. This is especially true because your profits should be considered against your margin, not the lot size, so it’s proportionately larger than it looks.

Profit and Loss

Now that we know how to figure pip values, let’s take a look at PROFIT AND LOSS. After all, that’s what we’re all here for: to make money.

Because we haven’t really used him before, let’s say that Bill is about to make a trade, and he’s planning on buying USD/JPY. We aren’t going to worry about margin, or rollover, but it’s impossible to cover profit or loss without considering the spread, which in Bill’s case is three pips. Bill likes to hold things for a while so he wants to wait for a solid rise before he sells.
Bill sees USD/JPY trading at 106.84/106.87 and believing the USD is going to rise against the JPY he buys one standard lot of $100,000 at 106.87. Remember you always buy at the higher price and sell at the lower. Because he’s buying, he pays the spread now as he enters or opens the trade. We’re not going to worry about pip value because we’re not going to realize the value until we close the trade.

Sometime later Bill sees that the exchange rate has changed to 107.37/107.40 and decides to sell. This is where he exits or closes the trade. Because he’s selling he has to take the lower price, just as he bought at the higher price (yes, the odds are stacked against you but that’s always the case and this is much fairer than a casino would be.)
So he sells his JPY and walks away with 50 pips.

What are 50 pips you may ask? If you’ve been following along for the last few pages you can probably figure it out, but let’s do it anyway:
USD/JPY = 107.37 (The rate we close the trade at)
0.01/107.37 = 0.0000931 (Pip value)
$100,000 x 0.0000931 = $9.31 (Pip value for this standard lot)
$9.31 x 50 pips = $465.50 (profit)
Not bad at all.

Now we talked about the trading spread earlier, this is where you can really see it in action. When Bill bought USD/JPY he used the offer, which is the higher of the two prices. With the 106.84/106.87 quote that meant he paid the 106.87. When he closed the trade, he sold at the bid price, which had risen to 107.37, giving him 50 pips in profit. Now in order for him to make that profit, the bid had to rise 53 pips before he could see fifty.
Paying the spread is accounting for those extra pips.

In this trade, Bill bought USD/JPY so he paid the trading spread when he entered the trade. If he’d sold USD/JPY he would have opened the trade by selling USD/JPY at 106.84 and then closed it buy buying USD/JPY at 07.40 and taken a bath with a loss of 56 pips. This is because when exiting a sell you close at the buy price which in this case had moved 56 pips from the opening sell price of 106.84.

In both cases the USD rose 53 pips against the JPY and Bill had to pay 3 pips for the privilege of trading. Those three pips increased his loss or decreased his profit. It’s the house cut and you’re always going to have to pay it.
Now you know what to do: Buy low, sell high. That’s a good beginning, but in order to succeed in the market one needs to know a little more about how to see patterns and make predictions. This was the easy part.

Reference: Forextraders.com

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