In forex markets, currency trading is conducted most frequently among the U.S. dollar, the Japanese yen, the euro, the British pound and the Canadian dollar.

A pip, an acronym for "price interest point", is a tool of measurement related to the smallest price movement made by any exchange rate. Currencies are usually quoted to four decimal places, meaning that the smallest change in a currency pair would be in the last digit. This would make one pip equal to 1/100th of a percent, or one basis point. For example, if the currency price we quoted earlier changed from 1.1200 to 1.1205, this would be a change of five pips.

A currency pair such as EUR/USD, for example, represents the relationship between the euro and U.S. dollar. The first currency is the base currency and the second currency is the quote currency. So, to buy EUR/USD at 1.1200 on a trade for 100,000 currency units, you would need to pay US$112,000 (100,000 * 1.12) for 100,000 euros.

To get the value of one pip in a currency pair, an investor has to divide one pip in decimal form (i.e., 0.0001) by the current exchange rate, and then multiply that number by the notional amount of the trade.

Four major currency pairs are the most traded and have the highest volume. These are known as the major pairs. They are the EUR/USD, USD/JPY, GBP/USD and the USD/CHF. These pairs all contain the U.S. dollar. In yen-denominated currency pairs, a pip is only two decimal places, or 0.01. This is 1/100th of a cent. Currencies are often traded in lots that are 1,000 units of the underlying currency.

To demonstrate how pips work in currency pairs, consider the example for the EUR/USD currency pair. Let's say the value of one pip is 8.93 euros ((0.0001/1.1200) * 100,000). To convert the value of the pip to U.S. dollars, just multiply the value of the pip by the exchange rate, so the value in U.S. dollars is $10 (8.93 * 1.12).

The value of one pip is always different between currency pairs because of differences between the exchange rates of various currencies. A phenomenon does occur when the U.S. dollar is quoted as the quote currency. When this is the case, for a notional amount of 100,000 currency units, the value of the pip is always equal to US$10.

The Relationship of Pips to Profitability

Whether a trader makes a profit or loss depends on the movement of a currency pair. A trader who buys the EUR/USD will profit if the Euro increases in value relative to the US Dollar. If the trader bought the Euro for 1.1835 and exited the trade at 1.1901, he or she would make 1.1901 - 1.1835 = 66 pips on the trade.

Let's now look at a trader, who buys the Japanese Yen by selling USD/JPY at 112.06. The trader loses 3 pips on the trade if closed at 112.09 but profits by 5 pips if the position is closed at 112.01.

While the difference looks small in the multi-trillion dollar foreign exchange market, gains and losses can add up quickly. For example, if a $10 million position in this set-up is closed at 112.01, the trader will book a $10 million x (112.06 - 112.01) = ¥500,000 profit. This profit in US dollars is calculated as ¥500,000/112.01 = $4,463.89.