Understanding Pips and Spreads (Part 1/2)
As a newcomer to trading in the forex market, some of the terms you are exposed to will be overwhelming. Do not despair – with information from the right sources, it will soon become like a second language. This article will explain the concepts of pips and spreads in a simple way, and how they relate to your profitability and risk management. For our purposes, we will focus here on the most commonly traded asset – currency pairs.
A broker buys and sells assets from/to traders. A spread is the price difference between what a broker sells an asset at, and that broker is willing to pay to buy the same asset.
Understanding Pips and Spreads (Part 2/2)
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, the 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 help you to be successful at 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 terms and definitions.
Simplifying Spreads (Part 1/2)
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 USD/JPY is 3.5. It means that your broker is selling USD/JPY 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 trader 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.
Simplifying Spreads (Part 2/2)
Traditionally, brokers have ask values that are higher than the bid values for the same asset, with this normally serving as a 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 closer to the same value that the broker pays for them. This is why low spreads are prominently displayed in advertisements, and rightly so. Traders academy is proud to follow this trend, and provides a trading experience that complements the lowest spreads very well.
Measuring Movement in Pips (Part 1/2)
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.
As you read in the spreads section above, when you see the spread value of an asset like USD/GBP at 1.5 for example, it means the spread is 1.5 pips of USD/GBP.
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.
Measuring Movement in Pips (Part 2/2)
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 (Part 1/2)
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:
Example 1: Let’s calculate the value of one pip in Euros, for one lot of EUR/USD 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 value = (one pip / exchange rate) * lot size (Part 2/2)
Example 2: We calculate the value of one pip in US dollars, for one lot of USD/JPY at 117.0804.
The calculation would be:
(1.01/ 117.0804) * 100,000 = $8.54 per pip
By learning and retaining knowledge of how pips and spreads work alongside each other is important, as traders are able to assess and react faster to good opportunities and more easily analyze exact profit and loss values.
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