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Learning Forex: What Are Pips and Spreads?
As you begin to familiarize yourself with Forex trading, you are bound to come across many new terms. Two of the most commonly used Forex words are “pip” and “spread”. These have unique definitions in relation to currency trading, and for beginners, we wanted to help you better understand what each of these terms means.
What is a Pip?
In Forex trading, a pip – which is short for “price index point” – is a numerical value that represents the amount of an exchange rate has changed over a period of time. Thus, a currency pair gains or loses pips over time.
In the majority of currencies, pips are valued to four decimal places, which means that one pip is 0.0001 and two pips is 0.0002. So if you closed a USD/CAD trade at 1.3320, after gaining 20 pips, the new value would be 1.3340.
The Japanese yen, however, is an exception, as the JPY is not valued to four decimal places. JPY is valued at two points. So a JPY currency pair, like USD/JPY, could be 122.50. In this scenario, one pip is 0.01 and two pips is 0.02.
Finally, some brokers offer fractional pip values down to 3 or 5 decimal places, called pipettes. Pipettes are equivalent to 1/10 of a pip.
Pip Value Calculation
When we talk about currency pairs, we can say that the USD/CAD gained 20 pips over a certain period. But what is the monetary value of those 20 pips? It requires some basic math, but the math is quite simple. To determine the pip value, you will need:
currency pair
Trade size
Closing exchange rate
So, for example, if you close a $100,000 GBP/USD trade at 1.5188 after gaining 20 pips, you would calculate the pip value by first determining how many US dollars each pip represents. In this case, the equation is 100,000 x 0.0001 or each USD equals 10 pips. Then you will calculate the price per pip in GBP using the closing exchange rate – or 10/1.5188 = 6.58 GBP per pip. Finally, calculate the value in GBP that the currency pair has changed to determine the profit or loss – in this example it would be 20×6.58 = 131.60 GBP.
What is propagation?
In Forex jargon, “spread” refers to the difference between the buying and selling prices of the currency which are set by brokers. These values are often referred to as “bid” and “ask” prices, and in the simplest terms, these are the prices that brokers offer to buy and sell currencies from a trader.
Brokers always offer lower bid prices than ask prices, because that’s where the broker makes money. So, for example, the bid/ask prices for EUR/USD could be 1.0757 and 1.0761; the currency pair is said to have a 4 pip spread. This means that if you entered into a trade and immediately liquidated it at the same exchange rate, you would incur a loss and lose money. In general, close spreads are better for traders because it is easier for a trade to become profitable. For example, if a pair’s spread was 55 pips, a gain of 20 pips would cause the trader to lose money; but if the same pair was 4 pips apart, that trader would be up 16 pips after closing the trade.
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