Traders use pips to measure price movements in currencies. Determining the number of pips in a certain price movement is a straightforward process, although it depends on the instrument traded.
In forex, the smallest price change is that of the last decimal point. Given that most major currency pairs, such as those involving USD, EUR and GBP, are priced to four decimal places, a pip in this scenario is a price movement of 0.0001. For example, if GBP/USD moved from 1.4000 to 1.4001, it has moved by one pip.
Comparatively, JPY currency pairs are only quoted to two decimal places. In this case, a pip is a price movement of 0.01. For instance, if GBP/JPY moved from 150.00 to 150.05, it has moved by five pips. Here are some examples of pips in forex trading.
If a trader entered a long position on GBP/USD at 1.5000 and it moved to 1.5040, the trader has made a profit of 40 pips. On the other hand, if the trader went long on GBP/USD at 1.5000 and the exchange rate fell to 1.4980, the trader has made a loss of 20 pips. Similarly, if the trader went long on GBP/JPY at 145.00 and it moved to 145.75, the trader has made a profit of 75 pips. If the exchange rate went against the trader, and GBP/JPY fell to 144.20, the trader has made a loss of 80 pips.
In CFD trading, a pip represents the minimum amount by which the underlying asset needs to change in value before the CFD changes in value. So, for a CFD on a US-listed stock, a pip might be $0.01. If a trader purchased a CFD on a stock at $5.00 and it moved to $5.10, that amounts to a profit of 10 pips.
Apart from measuring price movements and profit and loss, pips are also useful for managing risk in trading and for calculating appropriate amounts of leverage to use in trades. For example, a trader can use a stop-loss order to set the maximum amount he is willing to lose in terms of pips on a trade. Having a stop loss in place will limit losses if the trade moves in the wrong direction.