As you begin to learning about Forex trading, you're 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 mean.
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What is a Pip?
In Forex trading, a pip - which is short for "price index point" - is a numerical value that represents the amount an exchange rate has changed over a period of time. So a currency pair gains or losses pips over time.
In the majority of currencies, pips are priced to four decimal points, meaning one pip is .0001 and two pips is .0002. So if you closed a trade in USD/CAD at 1.3320, after a 20-pip gain, the new value would be 1.3340.
Japanese yen, though, is an exception, as JPY is not priced to four decimal points. JPY is priced to two points. So a JPY currency pair, like USD/JPY, might be 122.50. In this scenario, one pip is .01 and two pips is .02.
Finally, some brokers offer fractional pip values out to 3 or 5 decimal points, which are referred to as pipettes. Pipettes are equivalent to 1/10 of one pip.
Calculating Pip Value
When we talk about currency pairs, we might say that USD/CAD has gained 20 pips over a certain period. But what is the monetary value of those 20 pips? This requires some basic calculations, but the math is pretty straightforward. To determine the pip value, you'll need the:
Currency pair
Size of trade
Closing exchange rate
So for example, if you closed a $100,000 GBP/USD trade at 1.5188 after a 20-pip gain, you would calculate the pip value by first determining the number of U.S. dollars each pip represents. In this case, the equation is 100,000x.0001 or each USD equals 10 pips. Then, you would 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 the currency pair has changed to determine profit or loss - in this example, it would be 20x6.58= 131.60 GBP.
What is Spread?
In Forex lingo, the "spread" refers the difference between the buy and sell prices for the currency which are set by brokers. These values are often referred as the "bid" and "ask" price, and in the simplest terms, these are the prices that brokers are offering to buy and sell currencies to a trader.
Brokers always offer lower bid prices than ask prices, because this is where the broker makes money. So for example, the bid/ask prices for EUR/USD might be 1.0757 and 1.0761; the currency pair is said to have a 4-pip spread. That means if you entered into a trade and immediately liquidated that trade at the same exchange rate, you would record a loss and lose money. In general, close spreads are better for traders, because it's easier for a trade to become profitable. For example, if the spread of a pair was 55 pips, a 20-pip gain would lose the trader money; but if the same pair had a 4-pip spread, that trader would be up 16 pips after closing the trade.
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