Pips and Spreads
A trading account is formed out of 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 like 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 that starts trading the Forex market. They are part of the forming 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 them both. The number of pips is giving the actual profit of loss, while the spreads are showing part of the potential cost associated with any given trade, no matter if it will be 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 have an idea if the broker is a dealing desk or no-dealing desk, an ECN (Electronic Communication Network) or STP (Straight Through Processing). This, in turns, helps a trader picking up the right type of a trading account or the trading account that fits more 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 as for 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 on the moment an important economic data is released.
What is a Pip?
A pip is defined as the difference between the ask (the price at one can buy a currency pair) and bid (the price at which a currency pair can be sold) price, 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 EURUSD 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 is showing how the trade moved since its opening.
As it can be seen, the 93 USD profit corresponds to a value of 1.07272 (the ask price in the EURUSD pair on the top left of the chart). This would be the price used to square the trade, as the short position will 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 equals 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. Here, one needs to be very careful. A pip is referring, at least in the case of the EURUSD (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 where having four-digit quotations for a currency pair, as there wasn’t a technology to allow the interbank pricing quotation to be offered to the retail traders in more than four digits. Now that is changed! ECN and STP technologies permit the Forex trader to have access to conditions that one could only imagine a few years ago. However, the notion of a pip remains the same, namely, it is referring to the fourth digit. Coming back to our example, it means that the 93 USD profit on the EURUSD trade corresponds to 18.6 pips profit. Keep in mind that this is in strong relation with 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 was higher. For example, if the trading volume was one lot instead of half of it, the profit would have been 186 USD, and so on. 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 only a loss trading 1 full lot, and the account would still be in trouble.
What are Spreads?
A spread is the difference between the ask and bid price in the quotation of a currency pair. Spreads are not the same for all currency pairs, as well as they are not the same for all types of trading accounts. Forex brokers that offer only four-digits quotation (these are market makers!) are having 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 being taken from the trading account when the trade is closed. Forex markets are extremely volatile surrounding important economic releases like the NFP (Non-Farm Payrolls) in the United States or when a central banker is holding 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 is happening 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 one the liquidity provider/providers the broker is working with. But anyways, this is a moment when spreads are bigger, hence the trading costs are bigger. Spreads are the lowest on the most liquid currency pairs (EURUSD, USDJPY, GBPUSD, etc., and in general all major pairs) and they are bigger in crosses. Exotic crosses like the AUDCHF, for example, are coming with over two pips spread and during low liquidity times, this can increase even higher. The conclusion of this article should be that spreads are variable for different currency pairs and for a different period of times during the trading day, and therefore trading costs are different. One can only look to strive having as little costs associated with the trading activity, so having in mind how spreads change 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 being made, the more profitable the trader is.
Recommended Further Readings
- Financial Products to Trade
– Different categories of financial products that a Forex Broker is offering for the retail clients, starting with the classical currency pairs, and continuing with commodities, CFD’s, indexes, etc.
- Forex Trading Sessions and Their Importance
– Explaining the differences between the three Forex trading sessions, what are their importance, ranking, etc.
- Forex Brokers Types – ECN or STP?
– What is ECN, STP, how d- brokers deal with client’s orders, advantages, and disadvantages of the tw- types.
- Opening a Live Trading Account
– Steps to open a live trading account with a Forex broker, starting with the time taken for the whole process, documentation to be sent, verification process, trading platforms to download, etc.
- Financial Products to Trade
Other Educational Materials
- “Analysis of spreads in the dollar/euro and deutschemark/dollar foreign exchange markets.” Goodhart, Charles, Ryan Love, Richard Payne, and Dagfinn Rime. Economic Policy 17, no. 35 (2002): 535-552.
- “‘Reverse Spreads Find the Trends’ Kamenshchikov, Sergey. , Futures Magazine (Modern Trader).” (2015).