We are all aware that there are three types of forex pairs being traded; direct, indirect and crosses. The difference between the three is the role played by the US dollar in the first two and its absence in the third.
Before we get to the calculation part, involving these forex pairs, let's look at the different pairs and understand the terms used in their calculation
Pip
Also called price interest point; It is the smallest change in the exchange rate of a forex pair. Since forex pairs are usually quoted in four decimals with the Japanese yen being an exception, pip is a change in the fourth decimal and a change in the second decimal in forex pairs involving the yen.
Pips are taken as the fifth and the third decimal's when quoted in five decimals for the majors and in three decimals in case of the yen.
Lot Size
Is also called contract size and can vary from 10,000 to 10,000,000. The regular lot size is usually considered to be 100,000.
Lot size is directly associated to pip value; larger the lot size, higher the pip value and greater the profit/ loss per pip
Forex pairs
1) DIRECT FOREX PAIRS
If the domestic or the local currency is taken as the base and quoted in fixed units to the US dollar, the pair is termed as a direct forex pair
Let us take the case of the Australian dollar, which is quoted at 1.0350 to the greenback.
Since the Aussie is the base currency, it is quoted in fixed units whereas the US dollar is quoted in variable units.
Therefore, at the above exchange rate, 1 Aussie buys 1.0350 US dollars
Some of the other direct forex pairs are the EUR/USD, GBP/USD and the NZD/USD
Calculating pip value
Calculating pip value is very simple in the case of direct currencies and is calculated using the following formula
Pip Value= number of lots * lot size * number of pips
Problem
A trader buys 1 lot of GBP/USD which is quoting at 1.5250, lot size 100,000. After an hour, the exchange rate increases to 1.5266. How would the trader calculate profit/ loss?
Solution
Profit/ loss= number of lots * lot size * number of pips
= 1 * 100,000 * 0.0016
= $160
The trader, therefore, has incurred a profit of $160 on the GBP/ USD position
2) INDIRECT FOREX PAIRS
If the US dollar is taken as the base currency and quoted in fixed units to the domestic currency, while the domestic currency is quoted in variable units to the US dollar, the pair is termed as an indirect forex pair.
The most popular indirect forex pair is the USD/JPY and if it is quoted at 99.65, it indicates that 1 US dollar buys 99.65 Japanese yen
Some of the other frequently trades indirect forex pairs are the USD/CAD and the USD/CHF
Calculating pip value
Pip value = (number of lots * lot size * number of pips)/ exchange rate
Problem
A trader sells 2 lots of USD/JPY, which is quoting at 99.75, lot size 100,000. After 15 minutes, the exchange rate is at 100.20. How would the trader calculate profit/ loss?
Solution
Profit/ loss = (number of lots * lot size * number of pips)/ exchange rate
= (2 * 100,000 * 0.45)/100.20
= $898.20
The trader has a loss of $898.20 on the USD/JPY position
3) CROSSFOREX PAIRS
Forex pairs in which the US dollar does not play any role are termed as cross forex pairs.
The frequently traded cross forex pairs are the EUR/JPY, GBP/JPY and the EUR/GBP
In the EUR/JPY cross, EURO is the base currency and the Japanese yen is the variable currency.
Calculating pip value
Pip value = (number of lots * lot size * number of pips * base quote)/ exchange rate
Problem
A trader buys 1 lot of EUR/JPY, which is quoting at 129.10, lot size 100,000. After 30 minutes, the exchange rate is quoting at 130.20, while the EUR/USD is quoting at 1.3050. How would the trader calculate profit/ loss?
Solution
Profit/ loss = (number of lots * lot size * number of pips * base quote)/ exchange rate
= (1 * 100,000 * 1.10 * 1.3050)/ 130.20
= $1,102.53
The trader has a running profit of $1,102.53 on the EUR/JPY position
