PIP stands for Percentage in Point. A point is equal to one pip, so if you want to transact at a rate of 1.3000, it means the rate has moved by 30 pips. It’s different from forex quotes, where each quoted currency is worth 100,000 units of another currency (get more info here).
Every transaction automatically includes costs that include commission fees and PIP value changes between buying/selling transactions. The changing value of PIPs largely depends on the factors affecting forex rates, such as inflation rates or political actions in countries involved in any specific trade being executed using the foreign exchange market. Thus understanding how forex works will go a long way in helping you understand what PIP is and its effects on your trades.
Different models for how forex rates can be calculated
There are several different models for how forex rates can be calculated using variables such as interest rates, inflation rates and political actions. However, most traders consider a small set of rules that help them to calculate these changes in PIP values over a given time frame. These form the basic tenets of technical analysis that show the supply and demand for currencies between two countries.
Four time periods
One of the most common ways to think about PIP value changes is by looking at four time periods: short-term, mid-term, long-term and very long-term trends. A fifth category – intraday – is also used, but it’s not considered as widely as the other four categories.
For example, if you were trying to calculate PIP rates for a Euro/Dollar trade done at 1.3500, the large-term trend may be considered as down. It would indicate that you should expect to see a rate lower than 1.3500 in the next month as long as other factors such as inflation rates and interest rates also go down.
Calculating point changes
There are several ways traders can calculate points changes concerning each period’s end values, but most use statistical techniques to develop an average value change. It is known as an accumulative formula, where every day, new values are added until you cover all four time periods. These formulas are usually used by traders who don’t look at prices minute-by-minute but instead wait for hours or even days to do their trading, called position trading.
Supply and demand
Supply and demand theory is based on an economic strategy that shows how PIP value changes result from different traders trying to buy or sell particular currencies in large volume amounts.
For example, if you are buying Euros for Dollars, the Euro would be considered undervalued against the Dollar and should see a rise in value; hence, buyers push up rates according to the current market price.
Similarly, suppose you’re selling Euros for any other currency such as Yen. In that case, it follows that you will need more Yen than what is currently offered in markets, and this pushes down exchange rates according to the prevailing prices at the time your trade was executed.
The same applies to the Dollar/Yen currency pair, where it is said that Yen is overvalued against Dollars.
Technical analysis uses statistics to predict future PIP value movements based on the volume of trades at specific prices. This method follows the supply and demand rule theory in forex trading. Still, like every other statistical model, some flaws cause PIP values to move off predicted rates unexpectedly. To that end, most traders keep an eye out for all sorts of indicators that may help them predict market volatility much better than relying purely on technical analysis models.
Online research tools
Forex traders use online research tools like charts to identify areas with strong support (resistance) levels at given price intervals to expect a quick jump up or a rapid drop down in PIP values. Traders try and buy undervalued currencies and sell those that seem to be over-priced. A trader will ultimately buy Euros for Dollars if he expects the Euro value to increase against the Dollar since this would result in a profit on his trade at current market rates once the deal is closed.