Pips
When you buy something in a store in the United States, the smallest unit of price is 1 cent. This is because the coin with the least value is the penny, and so it would not be possible to sell or buy something for less than that, if only a single item is purchased, as is usually the case. Thus, a grocery store cannot sell a loaf of bread for $2.001, because there would not be any way for the customer to give the grocer 1/10 of a cent, since there is no coin for that. The only way that the grocer can actually get $2.001 per loaf of bread is to require that the customer buy at least 10 loafs of bread for $20.01. But the customer is not likely to buy so many loaves of bread, so the grocer can’t sell the bread for $2.001.
However, because the quote currency is valued as a unit of the base currency, which makes it easier to compare different currency values and changes in currency values, and because a large amount of currency is usually traded, a smaller unit of measure is convenient in expressing currency prices.
This smaller unit is called a pip, which is equal to .0001 of the base currency, for most currencies. In U.S. dollars, it is equal to 1/100 of a cent.
Thus, 10,000 pips = 1 dollar.
A well known exception to the value of a pip is the Japanese yen. Because the yen has much less value than the United States dollar, a pip is considered to be only 1% of the yen. Thus, most currency quotes are expressed by 4 significant digits, and the Japanese yen is expressed to 2 significant digits. The pip is the smallest value quoted by brokers and dealers. (Sometimes you will see quotes in the news that have 5 or 6 significant digits. These quotes were probably transacted by banks for large amounts of currency, but the smallest quote given by almost all forex brokers is the pip.)
Bid/Ask Quotes
Most investors buy currencies from market makers, or dealers, in that currency, who are commonly referred to as brokers. A dealer makes money by buying at one price and selling a little higher. When the dealer sells, the trader is buying, and when the dealer buys, then the trader is selling.
The trader pays the broker's ask price (known as offer price), and the trader sells to the broker for the broker's bid price, and the difference between the prices is called the spread, which in currencies, is usually at least 4 pips. The bid price for the trader is always lower than the ask price, because that’s how forex dealers make money. If you want to buy currency, you have to pay the higher ask price, but if you want to sell currency, you have to sell it at the lower bid price. So if you were to buy currency, then immediately sell it back to the same dealer, the dealer would make money, and you would lose money.
Thus, the spread is the transaction cost of trading currency.
For major currencies, the spread is usually about 3 to 5 pips or more, depending on the dealer. For less frequently traded currencies, or for major currencies during high volatility or low volume, the spread can be much greater. Although many brokers advertise 2-pip spreads, you will rarely see spreads less than 4 pips.
The actual transaction cost is determined not only by the spread, but also by the lot sizes of currency trades. Most regular accounts trade in lots of 100,000 units, and so a pip, when multiplied by the size of the account, will equal 10 units of currency. Most mini-accounts trade in lot sizes of 10,000 units, and so a pip will equal 1 unit of currency. If the quote currency is the USD, then a lot size in a regular account is $100,000 and each pip difference is $10. For a mini-account, a pip would be equal to $1. If the quote currency is other than USD, then the pip value would have to be converted if you wanted to know your profit or loss in USD. Since there are 10,000 pips to each unit of currency, and most lot sizes are either 100K or 10K, the total pip value can be found by the following formula:
Total Pip Value = Lot Size/10,000 x Conversion Rate
When the quote currency is the trader's native currency, then there is no need to multiply by the conversion rate for that currency.
Quote Convention
The quote convention in forex is based on the fact that there are 2 quotes for any currency, the bid quote and the ask quote, both of which are expressed as a unit of the base currency.
The symbols show the currency pair, and the numbers list the bid/ask quote for the quote currency (thus the name!).
Base Currency/Quote Currency Bid/Ask
The bid price is usually expressed to 4 significant digits after the decimal point, which represents the number of pips. The ask price is usually expressed as the significant digits that are different in pips from the bid price. For instance, you may see a quote such as the following:
EUR/USD 1.3522/24
This means that if you wanted to sell Euros for dollars, you would get $13,522.00 for 10,000 Euros, but if you wanted to buy Euros with U.S. dollars, then you would have to pay $13,524.00 to buy 10,000 Euros.
This quotation is expressed in terms of the dollar, but if the quote currency is the Euro, then it would be quoted this way:
USD/EUR 0.7395/400
This is equivalent to the above quoted price, but it is expressed in Euros per dollar rather than dollars per Euro. You can find the equivalent quote by dividing 1 by the quote. Thus, 1/1.3522 = 0.7395 (rounded) and 1/1.3524 = .7400
Converting it back: 1/0.7395 = 1.3522.
Note that rounding errors makes the round trip conversion inexact, but you get the idea.
In forex trading software, currency quotes are generally displayed in 2 parts: the big figure and the dealing price. The big figure is the main price that is usually the same for both the bid and ask quotes. The dealing price is the last 2 digits of a currency quote that different for the bid and ask quote. Because it is more important in regards to trades, the dealing price is usually displayed in larger fonts in forex trading software.
 As you can see in this partial snapshot of trading quotes of 6 currency pairs as displayed by a forex trading platform, the dealing prices are much more prominently displayed and the bid dealing price is always lower than the ask dealing price. |
