To some very successful investors like George Soros, the pip can be a very powerful tool for making money. In fact, the pip is part of the reason why Soros has become such a famous investing name. For so many others, though, that three-letter acronym for "price interest point" can be the siren call to go down the rabbit hole that is the foreign exchange markets, a place where individual investors can do some very, very dumb things with their money.
So let's take a look at what exactly a pip is, how Soros used them and foreign exchange trading to make some huge investments, and why you -- the everyday investor -- should probably avoid the temptation of investing in the foreign exchange markets.
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What is it?A pip itself is a very simple thing. It is the lowest unit of measure that moves between two currencies. With a few exceptions, currencies are traded at 1/100th of a percentage point, so a pip is when the difference between two currencies moves that one-hundredth of 1%.
If you're thinking that's not much, then you are right. When trading currencies on the foreign exchange market, however, the price difference between two currencies can move several pips in one day. After all, the foreign exchange currency market is by far the largest trading market in the world, with about $5.3 trillion worth of currency trading every day versus about $28 billion that exchange hands on the New York Stock Exchange on any given day.
The other thing to note is that making money in foreign exchange currencies requires a lot of money and hence a lot of leverage, and that is what made Soros a household name.
Prior to the euro, much of Europe all had set currency rates. Basically, each set a fixed rate with a small band of wiggle room for each currency in Europe, which prevented any one country from devaluing its currency to make its products more competitive against other exports. That makes sense in theory, but that also means that each of those respective economies needs to move in lockstep. In reality, they don't, and so countries need to adjust their inflation rates up to prop up a currency against a stronger one.
When this situation arose between currencies of Great Britain and Germany in the early 1990s, Soros made a massive bet that the British pound was being propped up by unsustainable interest rates, and so he shorted it. Ultimately, interest rates became too high and Great Britain removed the fixed currency exchange rate, the pound devalued quickly thereafter, and Soros pocketed a cool profit in excess of $1 billion.
A dangerous thing for everyday investorsI'm sure that stories like Soros' make trading in foreign exchange markets sound very intriguing. Not only can you make a lot of money if you lay your cards right, but you can sound really smart doing it. I mean, who would you want to talk to at a party -- the person who just said, "I'm shorting the Egyptian pound right now" or the one who says, "I simply dollar-cost average into a bundle of stocks all the time"? That pound-shorting person sounds way more interesting to talk to.
In reality, though, foreign exchange trading carries with it an immense amount of risk because there is so much leverage involved. To make those 1/100th of a percentage changes add up to sizable profits, you need to borrow several times the amount in their brokerage account. The maximum that you can borrow is onlylimited to 50 times your principal amount, whichwould amplify any gain or loss by 100 times, a great way to watch your principal go up in smoke in a very short amount of time if things don't go your way.
Also, in the foreign exchange market, you are a very small fish in a fast-moving ocean with large predators ready to eat you up at a moment's notice. Since this market is dominated by large institutions that typically have trading algorithms that are able to respond to news and price fluctuations much faster than you, the average person trading in foreign exchange loses money 70% of the time according to a study byAite Group.70%!With that sort of chances at losses, you're better off making investments at the roulette table than in trading foreign currencies.
What a Fool believesKnowing what a pip is might help you better understand the world of foreign currency exchange, but that doesn't mean you should be opening a foreign currency brokerage account anytime soon. For every story of George Soros making a hefty profit, there are all too many everyday investors who lose their shirts in an exchange market that has worse odds than going on a bender at a Vegas casino. If you actually enjoy lighting your money on fire, then please go ahead and venture off into the land of pips and currency pairs. If not, then it's probably best to stick to investing in stocks over the long term.
The article What Is a PIP? originally appeared on Fool.com.
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