Currency exchanges are built around buying foreign currencies. For example, buying Euros with dollars, on the expectation that the Euro will rise against the dollar, allowing you to sell it later (and recoup a profit).

This type of pairing is called a currency pair, and the current price of a pair of currencies (how many dollars it takes to buy one Euro) is called the exchange rate. Exchange rates are measured in ten thousandths of a unit of currency; this “ten thousandth” of a currency unit is called a “pip” in Forex trading. For example, if a Euro costs $1.4328, that means it costs one dollar and 43.28 cents.

Making a profit on forex trading (at least as a day trader) means watching the fluctuations of pips. Continuing the example from above, if the price of the Euro were to change to 1.4331, it would have risen by 3 pips. Conversely, if it had dropped to 1.4318, it would have dropped by 10 pips. Depending on the currency pair, current events, the timing of the change, and other factors, currency exchange rates can shift by as many as 20 pips on a given news item.

The amount of profit you get on a shift in pips depends on what your minimum “lot size” is. Most brokers try to aggregate investor positions into lot sizes of 10,000 units of a given currency, so that a shift of a ten thousandth of a currency translates into a reasonable amount of money; nobody ever got rich buying Euros or dollars or Yen in single transactions. Where do you spend a ten thousandth of a dollar? By doing swings in increments of 10,000 currency transactions, you’re likely to make at least a dollar on each swing.

The exact ratio of how much you make per transaction or change in pips is derived by the following formula:

1 pip = 0.0001 * the exchange rate * the lot size. So if you’re dealing with an exchange rate of 1.50, 1 pip means that we make or lose a dollar fifty on the transaction for a lot size of $10,000.

Now, most currency brokers aren’t asking you to pony up $10,000 to make the transaction; rather they have minimum positions that typically start at $50 or $100. What they do is aggregate the investments of multiple investors to make up their lots, or to use as collateral for loans to buy lots of currencies. This is called leveraging assets, and is a standard technique in the financial industry.

You take out a small loan and hope that what you buy with it will sell for enough more than the loan’s cost that you still make a profit; done reasonably, it’s a sound investment tool. Done unreasonably…it’s a risk. Minimizing that risk boils down to setting limits – I will buy a currency at price X and sell it at price Y. Most automated currency trading software can be programmed to buy or sell currencies at specific price points or when they leave or enter certain ranges. Use this feature wisely.

By: Christopher Stirling