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Lesson 7 – Spreads and Pips

In order to make money in the forex market, a good working knowledge of the quotation conventions is imperative, as well as a strong understanding of other key details of the forex market.

A good place to start when it comes to understanding quotations would be with the minimum fluctuation in the exchange rate for a currency pair that is often known colloquially as a “pip”.

Definition and Size of a Pip

Interestingly, the word “pip” arose as an acronym for Price Interest Point or simply a point. The term describes the smallest unit that a currency pair’s exchange rate can fluctuate.

Although the Dollar value of a pip remains constant when the U.S. Dollar acts as the counter currency, currency pairs often have very different percentage moves expressed by one pip.

For example, a pip move in NZD/USD quoted at 0.7000 is roughly twice as large in percentage terms as the value of a one pip move in GBP/USD quoted at 1.4000.

Furthermore, the U.S. Dollar amount that a pip represents varies depending on the amount of leverage being used on a given transaction.

As an example, when a trader is dealing standard forex lots of 100,000 Euros at a leverage ratio of 100:1 with a 1,000 Euro margin deposit, the minimum fluctuation or pip value in EUR/USD would be $10 or a difference of 0.0001 on the exchange rate.

This high pip value differs considerably from the situation where they just trade the amount of 1,000 Euros without using any leverage. In this case, a pip is only worth $0.10.

Pips and Volatility

While a pip may seem like a nominal amount, currency pairs can move hundreds and even thousands of pips in a very short time frame.

This exchange rates volatility is one of the reasons that trading in the forex market represents one of the best trading opportunities around and has made a new generation of home based trading millionaires over the past few years.

Of course, volatility can also lead to trading losses if you find yourself on the wrong side of the market.

The Dealing Spread

The difference between the price at which one can purchase and one can sell a currency pair is generally referred to as the dealing spread or simply, the spread.

The lower part of the quoted dealing spread is the bid rate, which represents the highest price which the quoting party is willing to pay for the currency pair. The higher part of the dealing spread is the offer rate. This is the lowest price at which the quoting party is willing to sell that same currency pair at.

Many active traders will seek out brokers and market makers with the tightest bid/offer spreads in terms of pips. Most dealing spreads in the retail forex market range from one pip in very liquid currency pairs such as EUR/USD or USD/JPY to three to four pips in NZD/USD and AUD/USD.

Nevertheless, dealing spreads often widen considerably from those levels in anticipation of or just after a major economic data release, as well as after the announcement of some unsettling news for the forex market.

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