Understanding pips and spreads
What is a pip?
A pip stands for “Percentage In Point”. It is the smallest price movement any exchange rate can make in the forex market.
In forex, most currency pairs are quoted to 5 decimal places, with the pip value being the 4th decimal place. The exception to this rule are Japanese yen-based pairs, which are quoted to only 3 decimal places with the pip being the 2nd decimal place.
In forex, one pip is equivalent to 0.0001. A Japanese-yen based pair would look somewhat different, as one pip is equivalent to 0.01. If the exchange rate of USDJPY has a bid price of 110.65 and an ask price of 110.67, this would represent a 2 pip spread.
How do you determine the pip value? The monetary value of each pip depends on two factors – the 2nd currency in the pair being traded and the size of the trade.
Now we’ve discussed which decimal place represents the pip, let’s take a look at some more trading examples:
GBPUSD exchange rate
1.29823 (buy or ask price)
-1.29800 (sell or bid price)
= 0.00023 (spread) or 2.3 pips
USDJPY exchange rate
109.339 (buy or ask price)
-109.315 (sell or bid price)
= 0.024 (spread) or 2.4 pips
What is a spread?
The spread is the price difference between the bid and ask prices, which essentially means the price in which a trader can buy or sell an underlying asset. Every financial market has a spread. The spread is traditionally represented in pips, which is something we discuss in more detail below.
Below is an example of the spread being calculated for the EURUSD. The calculation is simple, it is the buy price (ask price) subtracted by the sell price (bid price). That will then determine the spread, also in pips.
EURUSD exchange rate
1.17181 (buy or ask price)
-1.17166 (sell or bid price)
= 0.00015 (spread) or 1.5 (pips)
How does market uncertainty affect spreads?
There are a number of factors which can influence the spread. These factors are:
- Time of day
- Market volatility
- Market uncertainty
- Market liquidity
Important economic data releases and central bank policy meetings are often the most common ‘scheduled’ events that can cause exchange rate spreads to widen, especially in the lead up to the release. Unscheduled events or market volatility caused by factors such as political turmoil can also result in wider spreads. In general, in a volatile market, spreads are wider than during quiet market conditions. It is often the case that once the market absorbs the event news or economic data, the wider spreads generally return to typical levels.
Points in CFDs
It is important not to get confused with the definition of points when trading forex or CFDs because points when referring to CFD trading means something different.
For example, your rolling daily cash price for FTSE might be 7500 bid and 7501 ask. This would be referred to as a 1 point spread.