Pips and Spreads in Forex
Understanding the numbers by which the foreign exchange market is measured requires the knowledge of pips and spreads.
This article will explain in a simple way the concepts of pips and spreads concerning foreign exchange. Remember that when an asset is referenced, the subject will always be a currency pair.
A broker sells assets to traders and also buys them. A spread is the price difference between what a broker sells an asset at, and what a broker is willing to pay to buy that same asset.
The value of most currency pairs are measured up to the fourth decimal point. A pip represents the smallest movement in the pair, meaning 1/100th of one percent or a single tick of that last decimal. They can also be called basis points.
When discussing forex with a fellow trader, a universal knowledge of what pips, spreads and other important terms refer to means that complicated financial concepts can be understood with ease.
This is key to the efficient absorption of information that will aid you in brisk trading. These terms also populate most market news articles and analysis pieces published today. This is why any beginner who is looking to become serious must strive to understand forex vocabularies.
What is a spread?
In the simplest of terms, spreads refer to the difference between the buying price of an asset like a commodity, a stock or a currency pair and their respective selling prices. This is entirely different from profit, as a spread is the difference in these two values at a given moment.
For instance, you may see that your broker’s current spread on USDJPY is 3.5. It means that your broker is selling USDJPY to traders for 3.5 pips higher than what they buy it for.
Instead of saying ‘buy’ or ‘sell’, forex traders use the terms ‘bid’ and ‘ask’. To make it easier to remember, the price that a broker is asking for when selling to a traders is called the ask price, while what the same broker bids for an asset when purchasing it from traders is called the bid. Therefore, a spread can also be referred to as the difference between bid and ask.
Traditionally, brokers have ask values that are higher than the bid values for the same asset, with this normality serving as an vehicle to balance the risk that the broker shoulders for their role in this exchange.
Lower spreads are seen as discounts for traders, as they are buying assets from the broker for nearly the same value that the broker pays for them. This is why low spreads are prominently displayed in advertisements, and rightly so. Alvexo is proud to follow this trend, and provides a trading experience that compliments the lowest spreads very well.
What is a pip?
A pip is 0.0001 of the underlying asset. Why 0.0001? Because currency pairs and similar instruments are measured down to this decimal point. Changes in value are measured at this decimal level and represent the smallest possible increment in movement.
Measuring movements in Pips
As you read in the spreads section above, when you see the spread value of an asset like USDGBP at 1.5 for example, it means the spread is 1.5 pips of USDGBP.
When converting a pip value to currency, in order to measure how much a trader has made or lost on a trade, there are several factors that come into the equation.
The first factor is which currencies are present in the pair. If the Japanese Yen is a currency in the pair, then a pip is simply one one-hundredth instead of the typical one ten-thousandth, or 0.01 instead of 0.0001.
The second factor is the lot size for the asset. Currency pairs are sold in lots of what is typically 100,000. The lot size helps in creating larger movements in the value of a pair. Because the market’s volume is so large, a significant movement in a currency could be as low as a 0.50% change, and unless you are trading large sums of money this type of change is negligible in terms of price movement and return.
The third factor is the denomination of your account.
Pip value = (one pip / exchange rate) * lot size
Note that this value may change depending on which currency your trading account is denominated in, or whether or not you need to apply the exchange rate to see the value of your return in your home country’s currency.
Here are some examples:
Pip calculation example 1: We calculate the value of one pip in Euros, for one lot of EURUSD at a price of 1.1140. The calculation would be:
(0.0001 / 1.1140) * 100,000 = €8.98 per pip
If we want calculate the value in USD, we do not need the exchange rate: it would instead read as (0.0001 * lot size).
0.0001 * 100,000 = $10 per pip
Pip calculation example 2: We calculate the value of one pip in US dollars, for one lot of USDJPY at 117.0804. The calculation would be:
/ 117.0804) * 100,000 = $8.54 per pip
By learning and retaining a knowledge of how pips and spreads work alongside other important trading vocabulary, traders are able to react faster to good opportunities and more easily analyze exact profit and loss values. Take your time to study a live example in the market now.