Pip and spread are the foundations of forex terminology and are crucial to learning trading. Imagine that you’re chatting with two trading friends. One of them is cheerfully announcing that he has just won over 500 pips from his positions; he then suggests the other friend joins his broker for tighter spreads. If you don’t know about these terms, you’d be at a disadvantage in this conversation, as well as limiting your trading knowledge. If this situation is familiar to you, read on to learn more about pips are spreads.
What Are Pips?
As you might know, the value of a currency or an asset is quoted by another currency, which then defined as a rate. A pip is a unit measuring the smallest change of that rate, normally the fourth decimals. At present, the fifth decimal is also considered, namely pipette.
For example, the exchange rate of EUR/USD rises 0.0005 from 1.2250 to 1.2255, this means the rate moves 5 pips up. It then suddenly drops to 1.2240; in this case, the EUR/USD exchange rate moves 15 pips down. Profit or loss is calculated by the change in pip.
However, the pip is not the same for every currency pair because its value is priced by the quoted currency. A pip of EUR/USD equals a pip of GBP/USD, as both are quoted by USD; a pip change means 0.0001 USD change. Yet, a pip move of GBP/EUR is equivalent to 0.0001 change in EUR.
There are other currency pairs whose pip is not the change in the fourth decimal. They are often currency pairs with high rates such as USD/JPY. The exchange rate of USD/JPY is 111.72, and a pip, in this case, is measured by the change in the second decimal or 0.01 JPY per pip.
What Are Spreads?
For every currency pair, there are always 2 different prices. The first one is the Bid price or the price you sell, the second one is the Ask price or the price you buy. The former is always lower than the latter and the gap between them is called the “spread”. This spread ends up in the pocket of the broker which you choose to trade with.
For example, the Bid price of EUR/USD is 1.2250, the Ask price is 1.2251. The spread of this is 1.2251 – 1.2250 = 0.0001 or 1 pip.
The brokers play the role of the intermediary in transaction; in other words, their profits do not come from speculation or the change in the rate of assets. Most brokers do not charge or charge their customer a very small commission for every trade, so the spread is the gain for their services.
The spreads are different between currency pairs . The most significant factor influencing the spread is the liquidity of two currencies. The higher the liquidity means the more trading activities, your buying or selling orders can be easily executed since there are plenty of corresponding offers out there. In contrast, the lower liquidity or fewer trading activities of a pair often leads to broader spread to compensate for the risk of the trade. As a result, the major pairs such as EUR/USD, USD/JPY and others have tight spreads while exotic pairs have wider ones.
In general, pip and spread should be at the front of your mind whenever you trade currency pairs. Ensure your broker also offers learning resources on pips and spreads, like this guide from Easymarkets, this is a sign that broker cares about properly educating its clients. Lastly choosing a currency pair with a proper spread and keeping an eye on the change of pip are the two key tasks for every trade you make.