IC Markets

Understanding Pips and Spreads

If you've just started exploring the world of forex trading, you may have come across terms like "pips" and "spreads." These concepts are essential to trading currencies, and understanding them will help you make informed decisions when entering the market. In this beginner-friendly guide, we'll explain what pips and spreads are, how they're calculated, and why they're important for forex traders.

What Are Pips?

A pip, short for "percentage in point" or "price interest point," is the smallest price movement in the forex market. It's a standardized unit of measurement, representing the smallest change in the value of a currency pair. The purpose of a pip is to provide a standardized way for traders to measure price movements and express their gains or losses.

Typically, a pip is equal to 0.0001 or one one-hundredth of a percent for most currency pairs. However, for currency pairs involving the Japanese yen (JPY), a pip is usually equal to 0.01 or one percent. For example, if the EUR/USD currency pair moves from 1.1000 to 1.1001, the change is 1 pip, whereas if the USD/JPY pair moves from 110.00 to 110.01, the change is also 1 pip.
Fractional Pips:
In recent years, many forex brokers have introduced fractional pips, also known as "pipettes," to provide more precise quoting. A pipette is equal to one-tenth of a pip, which allows brokers to quote currency pairs with an additional decimal place. This added precision can help traders better gauge price movements and make more informed trading decisions.

For example, if a broker quotes the EUR/USD currency pair at 1.10005, the additional fifth decimal place represents the pipette value. In this case, the price has moved up by 5 pipettes, which is equal to half a pip (5/10 = 0.5).

Why Are Pips Important?
Pips are essential for forex traders for several reasons:

Price movement measurement: Pips provide a standard way for traders to measure price movements and express their profits or losses. This uniformity makes it easier for traders to communicate and compare their performance with others.

Risk management: Understanding pips helps traders manage risk by allowing them to set stop-loss and take-profit orders at specific price levels. This can help traders limit their losses and lock in profits when the market moves in their favor.

Trade size determination: Pips can also help traders determine the appropriate trade size based on their desired risk level. By calculating the potential profit or loss in pips, traders can select the appropriate position size to achieve their risk and reward goals.

Calculating Pips

Calculating pips is a crucial skill for forex traders, as it allows them to track price movements and quantify their gains or losses. Here's a more in-depth look at how to calculate pips for different currency pairs and situations.

Standard Calculation:
For most currency pairs, calculating pips involves subtracting the old price from the new price and multiplying the result by 10,000. This is because most currency pairs are quoted to four decimal places, with one pip equal to 0.0001.

For instance, if the GBP/USD pair moves from 1.3000 to 1.3050, the difference in pips is (1.3050 - 1.3000) x 10,000 = 50 pips.

Calculating Pips for JPY Pairs:
For currency pairs involving the Japanese yen (JPY), such as USD/JPY or EUR/JPY, a pip is equal to 0.01 or one percent, as these pairs are quoted to two decimal places. In this case, you need to multiply the difference between the old and new prices by 100 instead of 10,000.

For example, if the USD/JPY pair moves from 110.00 to 110.50, the difference in pips is (110.50 - 110.00) x 100 = 50 pips.

Calculating Pips with Fractional Pips (Pipettes):
If your broker uses fractional pips or pipettes, you'll need to take the additional decimal place into account when calculating pips. A pipette is equal to one-tenth of a pip, which means you'll need to multiply the difference between the old and new prices by 100,000 for most currency pairs, or by 1,000 for JPY pairs.

For example, if the EUR/USD pair moves from 1.10000 to 1.10050, the difference in pips, including pipettes, is (1.10050 - 1.10000) x 100,000 = 50 pips (500 pipettes).

Converting Pips to Monetary Value:
To convert the value of pips into your account currency, you'll need to multiply the number of pips by the pip value for your specific trade size. The pip value depends on the trade size (measured in lots) and the exchange rate of the currency pair.

For example, if you're trading one standard lot (100,000 units) of the EUR/USD pair, and the pair moves 50 pips in your favor, the profit in US dollars would be 50 pips x $10 (pip value for one standard lot) = $500.

What Are Spreads?

The spread is the difference between the bid price (the price at which you can sell a currency) and the ask price (the price at which you can buy a currency). Essentially, it's the cost of trading in the forex market, which varies among brokers and can impact your profit potential. The spread is measured in pips, and lower spreads indicate more favorable trading conditions.

Fixed Spreads:
Fixed spreads remain constant, regardless of market conditions. Brokers that offer fixed spreads often have a pre-determined spread for each currency pair. This type of spread can be advantageous for traders because it provides a stable and predictable cost structure. However, fixed spreads are generally wider than variable spreads, which can result in higher trading costs.

Variable Spreads:
Variable spreads fluctuate depending on market conditions, such as liquidity and volatility. They can be narrower than fixed spreads during periods of high liquidity, but they can also widen significantly during times of low liquidity or high volatility. Brokers offering variable spreads often have a more competitive pricing structure, as they typically charge lower spreads when market conditions are favorable.

Broker Fee Structures:
Different brokers have various fee structures, which can impact the overall cost of trading. Here are some common types of fees to consider when choosing a forex broker:

Spread-based fees: Some brokers charge fees based on the spread. In this case, the broker may offer lower spreads, but they might charge a commission on each trade, which can be a fixed amount or a percentage of the trade value.

Commission-free trading: Some brokers offer commission-free trading, which means you don't pay a separate fee for each trade. Instead, the broker makes money from the spread itself. This type of fee structure can be attractive to traders who prefer a simple cost structure, but it's essential to compare the spreads to ensure they're competitive.

Calculating Spreads

Calculating spreads is vital for forex traders because it helps them evaluate the cost of trading and compare different brokers to find the most competitive pricing. In this extended section, we'll discuss how to calculate spreads, as well as the factors that affect spreads and their impact on trading.
Basic Calculation:
To calculate the spread, subtract the bid price (the price at which you can sell a currency) from the ask price (the price at which you can buy a currency). For example, if the bid price for the USD/CAD currency pair is 1.36329 and the ask price is 1.36332, the spread is 0.3 pips (1.36329 - 1.36332).

Factors Affecting Spreads:
Several factors can influence the size of the spread, including:

Market liquidity: In highly liquid markets, spreads tend to be narrower, as there are more buyers and sellers actively trading. In contrast, low liquidity can lead to wider spreads, as there may be fewer participants to match orders.

Volatility: During periods of high volatility, spreads can widen as market participants demand higher compensation for the increased risk of trading. Conversely, during periods of low volatility, spreads tend to be narrower.

Broker fees: The fees charged by brokers can also affect spreads. Some brokers may offer tighter spreads but charge a commission on each trade, while others may offer commission-free trading with wider spreads.

Impact of Spreads on Trading:
The size of the spread can significantly impact your trading results. Wider spreads increase the cost of trading, which can erode profits and make it more challenging to achieve consistent results. On the other hand, narrower spreads can lead to lower trading costs and potentially higher profits.
When evaluating the impact of spreads on your trading, it's essential to consider the following:

Trading frequency: If you're a frequent trader or use short-term trading strategies like scalping, tighter spreads are crucial, as the cost of trading can accumulate quickly.

Trading style: For long-term traders or swing traders, wider spreads may have less impact on overall performance, as the cost of trading represents a smaller portion of potential profits.

Risk management: Spreads can also impact your risk management strategy, as wider spreads may require larger stop-losses to account for price fluctuations.