Understanding The Math Behind Forex

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Defining “pip”
Pip stands for “Price Interest Point”. A pip is the smallest increment of price change possible for an exchange rate and is almost always quoted to four decimal places (1/ 0.0001). The only exception to this rule is the Japanese Yen which is quoted to two decimal places (1/0.01). One pip in a currency pair can be calculated by multiplying one pip in decimal form by the notional amount of the trade. ( Notional amount is the size of the base currency). For example:

Using EUR/USD, calculate 100000 EUR (1 Unit) x .0001 = $10 per pip For GBP/USD, calculate 100000 GBP (1 Unit) x .0001 = $10 per pip

Determining the value of a pip

The value of a pip is different for each currency pair because of differences in the exchange rates for each currency. The formula for calculating the value of a pip is as follows: (One pip/currency exchange rate) x (Notional Amount). For Example:

Using USDJPY the formula gives us
(.01/139.46) x USD 10,000 = $0.77
Or 77 Cents per pip

Using EURUSD the formula gives us
(.0001/.8942) x EUR 10,000 = EUR 1.1183

To convert the pip value to USD we multiply EUR 1.2283 X (EURUSD exchange rate)
EUR 1.1183 x .8942 = $1.00

For any currency where the currency is quoted first the pip value is always $1.00 per 10,000 currency units (mini lot) or $10 per 100,000 currency units (standard lot).

The effect of leverage on pip valuation

Leverage is the amount of money you are able to spend as a result of borrowing investment capital. Basically, the more leveraged you are, the riskier your position. As shown above, pip value is the effect that a one-pip change has on a dollar amount. It is important to note that pip value does not vary based on the amount of leverage used, but rather that the amount of leverage you have affects the pip value. Increasing your leverage increases the volatility of your position because small changes in pip value will result in larger fluctuations in your account value. For example: if you trade one standard lot of USDEUR a one pip move will result in a $10.00 change. But if you trade five standard lots of USDEUR a one pip move will result in a $50.00 change. Using leverage can increase the effects of a price movement tremendously, which means your account can be wiped out very quickly, but also you can make huge gains quickly. You need to use extreme caution when making leveraged trades. Do not enter a highly leveraged trade unless you are certain you know what you are doing or you will almost certainly lose all your money very quickly.

Calculating Profit or Loss on a trade

Calculating profit and loss is very easy. There are only two formulas to remember.

When USD is the quote currency (the second currency in a pair), the formula is:

Profit = Price Change in Pips x Units Traded

When USD is the base currency (the first currency in a pair), the formula is:

Profit = Price Change in Pips x Units Traded / Exit Price

Let’s say you buy EURUSD and the trade goes your way. There is an increase of 17 pips. If you traded a standard lot 17 pips would be .0017 X 100,000 =$ 170.00.

When the USD is the quoted currency (second currency in the pair) a pip is always worth $10.00 when a standard 100,000 unit lot is traded. When a mini lot is traded (10,000 units) a pip is always worth $1.00.

Now, let’s look at an example where USD is the base currency. We’ll execute a buy of 100,000 units of USD/JPY at 117.22. The price rises and we sell at 117.35.
We just made 13 pips.

To calculate our profit we use the second formula:

Profit = Price Change in Pips X Units Traded / Exit Price

Or
Profit = .13 X 100,000 / 117.35 = $110.78.

The math behind forex trading is simple, the hard part is determining which way the market will move for the currencies you are trading. Making this determination requires continuous research, analysis and learning.

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