Currency Pips and Rates Of Return
Every country around the world has a currency that can be traded, not all however, have decent daily volumes, and some lack liquidity to such a degree that they are used only by specialists for very specific reasons.
A currency pair that has good volume but does not include the USD on one side of it or the other can be referred to as an exotic pair; they may be regularly traded, but not to the degree of the major currencies. The USD is on one side or the other of 90% of daily currency trade.
The first named currency on any pair is called the base currency. For example: USD (US dollar)/CHF (Swiss franc) has the USD first, which makes the dollar the base currency. If the quoted price of USD/CHF is 0.8650 it means that $1 is equal to 0.8650 Swiss franc. If AUD/USD is quoted as 1.0968 it means that 1 Australian dollar is equal to $1.09.
Pips (Price Interest Points) are the units in which a currency pair moves. Each purchase of foreign exchange pairs is done in lots; it is the unit amount that the market uses to trade currencies. One mini lot is the smallest denomination that a trader can purchase. One pip of price movement will increase 1 mini lot’s value by $1 on average. One standard lot is the equivalent to 10 mini Lots, 1 pip of price movement will increase the standard lot by $10 on average.
In the chart below AUD/USD is valued at 1.0968, which equates to A$1.00 being worth US$1.0968. As the Australian dollar (NYSEARCA:AUD) is the first named currency that makes up a two-currency trading pair (Aud/Usd), it will be the Australian dollar that always gets bought or sold against the US dollar (Usd).
Aud/Usd Daily Chart
The minimum liquid contract that could be bought is one mini lot of Aud/Usd. One mini-lot will control A$10k. The use of margin required is between $1100 and $2000 and would be set aside from the account balance serving as the initial margin requirement, depending on which broker is used.
Currency pair movement is gauged in price interest points (pips), which would be points in equity trade, or ticks in commodity trade. Each pip of movement when 1 mini-lot (10k of currency is controlled) will be worth $1 of profit or loss. Aud/Usd moving from 1.0968 to 1.0969 would be 1 pip, and therefore equate to $1 of profit or loss (after spread).
When markets are trading at extended levels, or at yearly highs or lows, traders will be following a mantra of banking early and often, looking to bank near-term profits profit, and limiting exposure. The subsequent balance of any trade would limit exposure yet still keep a trader in the position.
When trends have formed and resistance is clear, banking early and often would be a disadvantage, as although exposure is contained, upside potential is then not properly maximized.
Each currency pair either pays interest or charges interest to hold through 17:00 ET (futures swap interest) depending on the overnight interest rate that each country has. For example if the U.S. interest rate was 1.00%, and the Japanese interest rate was 0.5%, buying the USD/JPY pair would pay 0.5% (yearly interest rate per 10k of currency held, per day) if the position is held through17:00 ET each day. Conversely selling the same USD/JPY pair will charge interest for holding it past 17:00 ET each day.
Most new forex traders soon become aware of the interest rates that each economy has, and soon know to add the interest charges into their potential trade plans.
A Tick is the smallest possible change in rate. The size of forex position can be a Standard Lot (controlling 100k of currency), or a Mini Lot (Controlling 10K of currency).
Pip Value (in P/L dollars) = Lot Size x Tick Size
When the base currency of a pair is Usd balanced (Direct Rate), such as Eur, Gbp, Aud, each pip of movement (rate of pay in P/L dollars) will be worth $1 per $10k controlled. That equates to one Eur, Gbp, or Aud equaling the pairs dollar value. Eur/Usd @ 1.4750 = One Euro @ $1.4750.
When the base currency of a pair has Usd named first (Indirect Rate), such as Cad, Jpy, Chf, each pip of movement (rate of pay in P/L dollars) will still be worth $1 per $10k controlled.
That equates to one Usd equaling the pairs cross value. Usd/Cad @ 1.0950 = One Dollar @ C$1.0950. The rate of pay in P/L dollar is only affected by those cross pairs that do not contain the Usd on one side or the other (Synthetic Pairs or Cross Rates).
For example the Eur/Gbp pair value is derived by the percentage movement in Eur/Usd / Gbp/Usd. The rate of pay in dollars on Eur/Gbp is Eur/Usd (Base Quote) @ 1.4650 / Eur/Gbp Rate@ 0.9150 = $1.60 per Mini Lot (10K), or $16.01 per Standard Lot (100k).
Points are connected to the equity and option arena, and Ticks are used in the Futures market arena as a rate of change unit.
Information, analysis and methodologies provided are for informational purposes only, obtained from sources believed to be reliable, and should not be used as a replacement for research by an individual investor or licensed investment professional. In no event should the content of this correspondence be construed as an express or implied promise, guarantee, or implication that profits or losses can be made or limited in any manner whatsoever. No guarantee of any kind is implied or possible where projections of future conditions are attempted.