Understanding PIPS and Spreads in Forex Trading

Posted by forex on August 21st, 2010

These days trading in the forex market is gaining popularity. More and more people are considering forex trading as a good investment option. However before dealing into forex market one should know the basics of the forex market, what are the risks involved in this field.

As we know that forex trading is always done into a pair of a two currencies. Buyer is buying one currency and in exchange paying another currency to the seller. Due to fluctuations in the exchange rates the value of the currency the buyer is holding is changing. When the buyer wants to close the deal, he is making profit or losses depending on the rate of the currency he is holding. 

PIPS and SPREADS are the most frequently used terms in the forex market.

Let?s try to understand these two terms.

PIPS

PIP is a short form of ?Percentage in Point?. It is very important to understand PIP because it is used for calculating profit or loss in the deal. PIP is a smallest part of price change in the currency pair rate. For most of the currencies it is 0.0001 or 1/100 of a cent. It is a small value, but currencies are traded in lot, it holds significant value. Say for the lot of 10000$, value of pip is . If a currency moves from 1.4510 to 1.4515, it is moved 5 pips. If a pip value is 1$ then you have gained 5$. However exception to this is Japanese Yen, where the value of PIP is 0.01 or 1 cent.

SPREADS

Spread is the difference between the bid price and the ask price. This is forex dealer?s price and not your price. The ask price is the price for which you buy currency from the forex dealer, and bid price is the price of a currency at which you sell currency to forex dealer. As an example, for EUR/USD currency pair, bid price is quoted at 1.4500 and ask rate is quoted 1.4505, spread is 5 pips. These 5 pips are the immediate loss for you. Because if you buy the currency and immediately sell it, that is the difference you are losing immediately. This is called SPREAD. To make the break even you have to wait till forex dealer?s bid price is 1.4505. Spread plays important role in calculating profit or loss. Less spread results into more profit and more spread eats a big chunk from your profit. Different brokers are offering different spreads. From the profitability point of view, it is necessary to find out a broker with lower spread. At the same time it is equally important to find out reputed broker. Generally brokers are offering lower spread to the clients who deal in large volume. Lower spread is a key to earn more profit.

I hope this article will help you understand PIPS and SPREAD.