What is a pip in trading: learn the basics of forex terminology
If you are just starting out with forex trading and you are baffled by all the jargon and terms you’ve never heard before, you’re in luck! In this article, we’ll look at all the important terms a trader needs to grasp before he can start trading effectively.
What is a pip in trading?
A Pip or price interest point or percentage in point as it’s commonly called is the smallest movement in the exchange rate between two currencies. On your trading platform, the pip is the fourth decimal in a quote and if the current exchange rate of a currency pair is quoted as EUR/USD = 1.5462 then the pip is the number 2.
In the above example, if the EUR/USD pair goes up to 1.5490, we can say that it went up by 28 pips. If you had gone long or bought the pair before the exchange rate went up, then your trade would be successful, and you would have gained 28 pips.
When a currency pair increases in value, the movement is measured in pips and forex traders usually measure their profits and losses in pips. It’s important to note, however, that a pip differs in value depending on the instrument you are trading and your position size. Trading EUR/USD with a position size of 1 standard lot means that each pip is $10 dollars. As such, by buying the pair, we have gained $280 (28 pips x $10) in profit in a quick single trade.
On the other hand, if the pair didn’t move in line with our initial assessment and instead dropped to 1.5450, then we would have lost $120 (12 pips x $10) pips instead. Thankfully, in forex, you can buy or sell a currency pair and therefore, there is an opportunity for profit regardless if the market is moving up or down – as long as the market is moving, there are pips to be made.
What is the difference between the bid and the ask price?
When you open the trading platform and see the stream of live exchange rates between the currency pairs, you’ll notice that there are two prices shown for each pair. For example, EUR/USD = 1.5462 / 1.5465. The first price on the left (1.5462) is called the bid and the one on the right (1.5465) is the ask.
The reason you are quoted with two different prices is that the market facilitates trades between buyers and sellers and these two groups have a different price at which they are willing to buy or sell a particular currency.
Put simply, the asking price (1.5465) is the number of units of the quote currency you will need to sell in order to buy 1 unit of the base currency. In the above example, the base currency is the EUR and the quote currency is the USD – left and right respectively.
To put everything together, when you are buying the EUR/USD pair, you are actually selling USD at the asking price (1.5465) to buy 1 unit of EUR. You only buy the pair when you believe the base currency (EUR) will go up against the quote currency (USD). Conversely, if you were selling the EUR/USD pair because you think the base currency (EUR) will depreciate against the quote currency (USD), you would be selling the EUR at the bid price (1.5462) to buy 1 unit of USD.
What is the spread?
This bring us to the spread. If you look again at the above example (EUR/USD = 1.5462 / 1.5465), there is a 3-pip differential between the bid and the ask price. These 3 pips are considered the spread or the commission your broker will receive for each trade in this currency pair.
The spread usually differs between currency pairs. The more popular and highly traded currency pairs enjoy lower spreads which is more favorable to the trader since it’s easier to achieve enough pips to make a profit – after you pay the spread needed to your broker.
You should also beware of volatility and fast-moving markets since spreads tend to change rapidly during abnormal market conditions and sometimes become high enough to turn a profitable trade into a losing one in mere seconds.
Major, minor and exotic currency pairs
Currency pairs are split in three different categories. The major pairs are the ones that have USD as the base currency of the pair. As we already mentioned, the most popular currency pairs are the ones that are most highly traded and thus have more trading volume and liquidity.
Therefore, it makes sense that the USD which is the most valuable currency in the world would be the base currency in almost every major. As such, the majors include the EUR/USD, GBP/USD, USD/JPY, USD/CHF, USD/CAD, AUD/USD and NZD/USD.
The minor currency pairs, on the other hand, are comprised by currencies that belong to economies which rely heavily in natural resources. If the value of the respective commodity drops, it will impact the value of the currency as well.
It’s important to note that these pairs aren’t as heavily traded as the majors and their liquidity is much lower and this translates to a higher spread pricing from brokers.
The minor currency pairs mainly include the currencies of three developed economies including the EUR, GBP, and JPY. These are the EUR/GBP, CAD/JPY, GBP/JPY, EUR/CHF among others.
The last and most volatile group is the exotics, which consist of the currency of an emerging economy on one end and the USD or EUR in the other – i.e. USD/HKD, USD/SGD, USD/SEK, and EUR/TRY.
Margin and leverage
To open a new position or to be able to trade a currency pair, commodity or stock, you need enough margin or funds available in your account to cover the cost of the position. Depending on the margin requirement set by your broker, however, you may only need a small percentage of the total position cost to open a trade. This is one of the main advantages of forex trading since it allows for trading larger positions with a smaller deposit and keeping the profit.
If you want to trade 100,000 units of EUR/USD and your broker’s margin requirement is 1% for this currency pair, then you only need $1,000 in your trading account as margin to cover the position. This is also referred to as leverage and in this instance, you have used a 100:1 leverage ratio for this trade.
Using leverage this way, you can increase your purchasing power and potential profits exponentially, but it’s a tool that should be used with caution as it also exposes you to greater risk – especially in fast-moving markets. If the trade doesn’t go according to plan and the market moves against you, you will stand to lose more than the money that you initially invested.