Pips and spread – the most important concepts in the currency market
One of the first things you need to understand while trying to learn Forex are so-called “spreads”. This is the most important information to understand the rules of forex. Spread is the difference between the price at which you sell the currency (the so-called “bid price”) and the price at which you buy a currency (the so-called “ask price”). It is presented using so-called “pips”. One pip is 1/1000th of a percent. Easiest way to explain it is by using an example: If at certain moment a price of EUR/USD is 1,4222/1,4223, then the spread is 1 pip. Different offer, at 1,4222/1,4232 would make a spread of 10 pips.
How banks and forex brokers make money on spreads? Wider spreads mean higher ask price (purchase price), and a lower bid price (selling price). If you already pay your loan contracted in foreign currency, you should more or less know what spread is. In the case of credit spread, the difference between the purchase currency (based on which the bank gave you money) and selling rate (at which the borrower repays the loan installment). As a result, your loan in foreign currency is calculated at a lower exchange rate and you repay it after the higher rate.
Currency exchange booths work on the same principle – they buy currencies for lower price and re-sell for higher. The difference, among with eventual commission is how they are making money. If they were to buy and sell the currencies using only forex price, that’d mean they are working for free. This mechanism of spreads is how currency exchangers, banks and forex brokers are staying afloat, the only thing that matters to you is to pick one forex broker that offers the best terms.
Most forex brokers don’t charge customers for the purchase or sale of foreign currencies – their profit is already included in the spread. Therefore, it is very important to check the available brokers and pick the one that offers the most cost-effective spreads. Of course, this is only one of the factors that should be taken into account, when selecting the broker and entrusting him your money. The spread is compensation for brokers for the risk they are incurring when handling their clients’ transactions.
In addition to the term if “spread”, another important term that must be learned is already mentioned “pip”. Pip is as I already said earlier, an unit of 1/100th of one percent, and is used to describe increases or decreases in the value of the currency. Understanding spreads and pips is the basis for the understanding of the whole system of currency trading.
Spread is measured on forex with usage of the pips. One pip is the smallest increment of price when trading on the forex – 1/100 of a percentage point. How is it possible to earn any money on forex without investing a lot of money? The answer is so-called “leverage”. When trading on forex, you can invest much larger sums of money than you actually have deposited on your account. This means that the price jump of just a few pips, can mean huge profits.
Rates of exchange are displayed when trading on forex to the fourth decimal place – for example EUR/USD – sale (bid price) at the level of 1.1914, buying (ask price) at the level of 1.1917. That means in this case that the spread is 3 pips. If the spread suddenly changed as the form of 1.1914 / 1.1919, would be 5 pips.
Pips changes are so important in forex trading, because it directly shows our profit or loss of any investment. If our currency pair will gains a few pips up, we earn, if it falls down, we lose.
The last term that you must learn to understand the basics of forex trading is currency pairs, around which revolves the entire forex market revolves. It all comes down to the fact that you are buying one currency with a specific value in relation to other currencies and its value, hoping that the value of the base currency rises against the value of the second currency – thus earning you a profit.
Different currency pairs have different spreads, due to their usual liquidity and turnover. Make sure to check the size of the spreads offered by different brokers before investing real money. Less often traded pairs have usually bigger spreads, which means that taking fees into account, the price must rise quite a bit before you see any actual profits – For beginning it’s best to stick to most popular ones.
Each transaction made on the forex market is buying one currency and selling of another, but it is much easier to think of currency pairs than individual currencies. When you buy a certain currency pair, you’re really buying a base currency and sell the other currency in the pair. The purchase price of a currency pair tells us how much of the other currency is needed to purchase one unit of the base currency.
On the other hand, when you sell a pair of currencies, you’re selling the base currency, and receive a secondary currency from the pair. The selling price of the currency pair tells us how much of the other currency from one unit of the base currency we are getting. Trade is always done in currency pairs and currency exchange takes place between the pair. Most major currencies exchanging is done based on US dollar ( USD is either primary or secondary currency).
Exchange rate tells you how many of the other currency pairs should pay to buy one unit of the base currency, and also how many of the other currency pair units we’d get for selling one unit of the base currency. For example, if the exchange rate for the EUR / USD is 1.2083. It tells the buyer of the Euro, that for one Euro you have to pay 1.2083 US dollar.
Despite the big variety of currencies in the world, the majority of investors in the forex focus only on the main world currencies, as they are the most predictable (and usually have the lowest spreads). Think of a situation where at the beginning of 2009, all Eastern European currencies depreciated against the euro, dollar and pound. On the one hand it was a huge gain for holders of large amounts of these currencies, who sold them. However, the lack of stability while investing in these currencies may prove to be counterproductive for short-term investments.
The main currencies on the foreign exchange market are:
USD – United States Dollar
GBP – British Pound
JPY – Japanese Yen
EUR – Euro
CAD – Canadian Dollar
AUD – Australlian Dollar
CHF – Swiss Fank
And the most often traded pairs are USD/JPY, EUR/USD, USD/CHF, GPB/USD. Currency pairs are usually traded in the amount of 100 thousand units of the base currency. For example, if buying EUR/USD at exchange rate of 0.97, this would mean that we’re buying euros for dollars with following equation:
100 000 x 0.97 = 97 000 euro for 100 000 dollars.
This applies analogously to all currency pairs.
Probably, thanks to the information displayed on this page, you already have elementary knowledge about the basics of Forex. To sum it up: Forex focuses mainly on currency pairs (mostly major currencies). You buy a particular currency, hoping that its value will increase (price is displayed in pips), so that you will develop your profits. This is of course the absolute basics. The most important thing to trade currencies profitably is to learn basic information about the currency markets, and learn why the value of currencies rising or falling.
Now that you have the basics of forex covered, the best way to understand and experience in practice how actual trading works is to open free training accounts on various platforms and brokers play the market using virtual cash. Put off investing of any real money for at least two weeks. Do some basic trades using virtual cash on training account, and once you feel you are ready, make your first deposit and start trading for real. You should read more tutorials on this page to get additional information and/or tips.