Understanding Forex Quotes and Pips (Part 2)

What is a PIP? And Spread?

With literally a world of different currencies, the Forex uses a standard tick increment of movement for all of them to define profit or loss. Utilizing this common tick, and as a function of the pair combination, Forex also offers an alternative to the typical commission-per-trade model.

PIP

How could price movement be defined for a multitude of global currencies, each with its own denomination? The Forex market uses a common minimum tick to define price movement and increments of profit or loss. The pip, actually an acronym for “percentage in point,” is the minimum tick incremental fluctuation for all Forex currency pairs. With all pairs but the Japanese Yen expressed in value to four decimal places, one pip represents a change in the fourth decimal place or 1/100th of 1%.

Looking again at the quote examples, we can calculate how many pips each currency moved during the trading day:

The EUR/USD climbed 91 pips from its open rate to the day’s high and fell 49 pips from the open to the low.

Though the GBP/USD pair would be denominated in British Pounds, it can be calculated that the pair moved up 50 pips from the open quote to the day’s high and fell 29 pips to the day’s low from the opening quote.

Though the quotes appear different, pips of movement will be calculated the same for these currency pairs:

The US Dollar advanced 49 pips against the Swiss Franc at its day’s high from the open quote. The Dollar fell 33 pips to the day’s low.

The US Dollar gained 88 pips against the Canadian Dollar when it reached the session high from the quote at the day’s open. The US Dollar dropped just 5 pips off the day’s open at its lowest for the day against the Canadian Dollar.

Lots

The actual monetary value of a pip of movement will vary by currency denominations and by lot size. When placing a trade on a currency pair, the standard lot size will be for 100,000 units of the base currency. A mini lot is one tenth the size at 10,000 units and a micro lot is one tenth of a mini lot at 1000 lots.

The EUR/USD pair uses the standard monetary value of a pip in US Dollars.
Calculate by multiplying 1 pip by the lot size.

Standard Lot: .0001 x 100,000 = $10
Mini Lot: .0001 x 10,000 = $1
Micro Lot: .0001 x 1000 = $.10

In the earlier example, the EUR/USD had moved 91 pips from the open to the day’s high. Entering a long position from the day’s open would have gained a profit in each lot size at the dollar amounts listed. A short position from the open quote would have resulted in a loss of 91 pips and the equivalent monetary value for each lot size when the EUR/USD reached the day’s high. These values are provided for example only. Past performance is not indicative of future results.

Standard Lot: 91 pips x $10 = $910
Mini Lot: 91 pips x $ 1 = $91
Micro Lot: 91 pips x $.10 = $9.10

Spread

Forex currency pairs are actually traded as spreads, a strategy that involves a simultaneous buy and sell. When a pair is traded, one currency is bought while the other is sold, though that is transparent to the trader. Going long with a pair will actually execute a buy for the base currency and a sell for the counter. Going short will sell the base and buy the counter.

A spread trade will profit or lose based on the difference between the two positions taken. Again, this will be transparent to the Forex trader who needs only to watch a single changing quote for any open position.

Strategies using combinations of positions such as spreads and straddles are no less risky than taking straight long or short trading positions.

The spread is also the term given to the tradeable quotes listed for a pair. Notice that the quote listed for any pair is never the same to buy or sell, as in this example:

In this example, a trader seeking to buy the EUR/USD pair could enter the position at 1.5528. A trader who wants to go short and sell the pair can enter the position from 1.5526. The spread here is 2 pips. The quote to buy will always be higher than the quote to sell.

Many traders are drawn to Forex because it is considered to offer “no commission trading.” Obviously, Forex dealers have to make money somehow! They make it here, on the spread. A dealer offering a two-pip spread will take two pips on each trade as compensation for their services. The payment feels transparent to the trader and is not charged as a commission on a statement.

Any fees or actual commissions charged to a Forex transaction could be for additional services rendered, such as for a managed account. Before opening a Forex trading account with any dealer or brokerage, be sure you understand the spread that will be charged and any possible fees or commissions that could be applied to your account.

Bid and Ask

Contrary to a common belief, price movement in any market is not solely determined by a preponderance of buyers or sellers but rather, by what prices the market will accept. Human nature is ultimately behind price movement.

The quotes listed on a Forex currency pair are called the Bid and the Ask, sometimes also referred to as the Offer. The bid is the highest price at which a pair may be sold, the ask is the lowest price at which it may be bought. The bid will always be lower than the ask. The market moves as each progressively lower bid is accepted by sellers and each progressively higher ask is accepted by buyers, similar to the manner in which advancing prices are accepted in an auction. Each transaction becomes the last price, setting a new benchmark for the next trade. This on-going process indicates the degree to which market forces are battling and when one side will overtake the other for a trend to begin to emerge.

Looking again at the previous example:

While many dealers will display quotes as “Buy” and “Sell” to reduce confusion, the Sell quote listed here is the Bid and the Buy quote is the Ask or Offer.

Various trading platforms may display quote information differently. This example offers each type of labeling to clarify:

Notice in this example, the spread is four pips.