Pips and Spreads

A trading account is formed from different elements that must be interpreted in the right way to fully understand the account’s potential. Previous articles here on the Trading Academy have covered notions such as an account’s balance, equity, free margin … and even went into explaining how a profit is made. Those notions are a must for anyone at the start of a trading career, or simply anyone who starts trading the Forex market. They are part of the formative process of every trader, and must be properly understood. Pips and spreads come to complete this picture, as profit or loss is heavily dependent on both of them. The number of pips gives the actual profit or loss, while the spreads show part of the potential cost associated with any given trade, regardless of whether it is a winning or a losing one. Spreads tell much about the Forex broker as well, as depending on how wide or tight they are, traders get an idea of whether the broker is a dealing-desk or no-dealing-desk broker, of the Electronic Communication Network (ECN) or Straight Through Processing (STP) type. This, in turns, helps a trader to choose the right type of trading account, or the trading account that fits best with the trading plan.

Why is it Important to Know What Pips and Spreads Are?

Pips are important as they define the loss or the win of a trade. Ask any trader the profit he’s made, and you’ll get an answer in real money; but if you ask about a loss, you’ll hear it defined in pips. Spreads, on the other hand, are associated with the cost of trading a specific currency pair. They are insignificant for some currency pairs, but quite big on some others; and on top of that, they vary based on both the time during the trading day and the moment an important of economic data is released.

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What is a Pip?

A pip is defined as the difference between the ask price (the price at which one can buy a currency pair) and the bid price (the price at which a currency pair can be sold), and it gives the profit or loss of any given trade. To continue with the same example as the one used in the previous two articles here on the Trading Academy, the EUR/USD short position was initiated at 1.07458, and now yields a profit of 93 USD before other costs associated with the trade. The image below shows how the trade moved since its opening.
Pips and Spreads - 1
As can be seen, the 93 USD profit corresponds to a value of 1.07272 (the ask price for the EUR/USD pair on the top left of the chart). This would be the price used to square the trade, as the short position would be squared with a long one. In other words, if the trader decides to take this profit and not to wait for either the stop loss or the take profit order to be hit, the 93 USD profit will be translated into the equivalent number of pips. This equates with the entry price (which was the bid price when the trade was taken) and the close price (the ask price when the trade is closed), or 1.07458 and 1.07272. One needs to be very careful here, though. A pip refers, at least in the case of the EUR/USD (but for many other currency pairs as well), to the fourth digit in the quote!

What is the Value of a Pip?

Until a few years ago, trading accounts had four-digit quotations for a currency pair, as there wasn’t the technology to allow the interbank pricing quotation to be offered to the retail traders in more than four digits. Now that has all changed! ECN and STP technologies allow the Forex trader access to conditions that one could only imagine a few years ago. However, the notion of a pip remains the same: namely, it refers to the fourth digit. Coming back to our example, it means that the 93 USD profit on the EUR/USD trade corresponds to 18.6 pips profit. Keep in mind that this is in strong relation to the volume traded: in this case 0.5, or half a standard lot. In other words, the same number of pips would have generated a bigger profit if the traded volume had been higher. For example, if the trading volume was one lot instead of half of it, the profit would have been 186 USD, etc. Therefore, the value of a pip tells much about the potential profitability of a trading account. One can make hundreds and hundreds of pips trading 0.1 lots, and a loss by trading only 1 full lot, and the account would still be in trouble.

What are Spreads?

A spread is the difference between the ask and bid prices in the quotation of a currency pair. Spreads are not the same for all currency pairs, just as they are not the same for all types of trading accounts. Forex brokers that offer only four-digit quotations (these are market makers!) have higher spreads than brokers that offer ECN and/or STP execution. A spread is a cost or a fee that the trader must pay, and it is taken from the trading account when the trade is closed. Forex markets are extremely volatile surrounding important economic releases such as the Non-Farm Payrolls (NFP) in the United States, or when a central banker holds a press conference. During these times, spreads are widening, making it more expensive to open or close a trade. When liquidity is thin, spreads have the tendency to be bigger as well. This happens when the North American session is ending, and there are still a few hours until the Asian session starts. During this period, spreads are higher on all the currency pairs, but even this differs from broker to broker as it depends on very much on the liquidity provider/s the broker is working with. All these other factors aside, this is a moment when spreads are bigger, hence the trading costs are bigger. Spreads are the lowest on the most liquid currency pairs (EUR/USD, USD/JPY, GBP/USD, etc., and in general on all major pairs) and they are bigger in crosses. Exotic crosses such as the AUD/CHF, for example, come with over 2 pips spread, and during low liquidity times this can be even higher.

The conclusion of this article should be that spreads are variable for different currency pairs, and for different times during the trading day, and therefore trading costs vary accordingly. One can only strive to have as little cost associated with the trading activity as possible, so having in mind how spreads change can greatly influence profitability. Pips, on the other hand, refer to the actual profit or loss the trade will result in, and they are a measure of a trader’s success. The more pips are made, the more profitable the trader is.

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