In currency trading, the concept of forex pips is one of the most vital, yet it can also be one of the most confusing. Understanding pips is important because it determines how much you will earn in a trade.

Basically, pips are the smallest price movement any exchange rate (the price of one currency expressed I units of another) can make. For example, the value of the euro on Wednesday was $0.8075; the next day it strengthened to $0.8073. Since the difference is $0.0002, you can say the euro gained two pips.

Exchange rates are commonly expressed up to four decimal points (with the exception of the Japanese yen which is measured in two decimal points) and price movements are usually incremental; hence, forex pips can also be computed by multiplying them with the size of the trade. Assuming you traded a typical lot of 100,000 euros, the value of one pip would be 0.0002 multiplied by 100,000 or $20.00. To convert the value of the pip to euros, just divide the value in dollars by the exchange rate. In the example above, the value of one pip would be 24.77 euros.

The premiums you pay when opening an options contract are also computed in pips. For example, you believe that the euro will further strengthen against the dollar, so you take out an option contract to buy 100,000 euros at $0.8072. If the broker believes that the risk for him is too high, he may quote a premium of 20 pips or $200.
As a currency trader if you understand how forex pips are computed you can easily determine your profit or loss in a particular trade.

Source by Timothy Stevens