In our last article, we took a look at some of the terminology understood and used by Forex traders, and now we’re going to provide some application of those terms so you can begin your trading the right way.
You may recall what is perhaps the most important term you can learn — “Pip,” which is the smallest price change that a given exchange rate can make, and the way traders track their wins and losses.
We also mentioned that traders can choose a lot size — standard, mini, or micro — and because of the different lot sizes the monetary value of a pip you win or lose can vary according to the size of your trade and the currency you are trading.
Many traders choose the mini lot size, which uses increments of 10,000. A lot size of 10,000 for the EUR/USD is worth $1.00 per lot, so if you chose to trade 3 lots (or 30,000 in total), each pip is worth $3 in profit or loss. A full size lot, or standard lot, is 100,000 where each pip is worth $10, and a micro lot size is 1,000, where each pip is worth $0.10.
Some currency pairs will have different pip values. Be sure to check with your broker, or consult the software you use to plan your trades for information about currencies and their current pip values
A 5 pip spread for EUR/USD is 1.2530/1.2535
One of the nice things about trading currencies is there is no commissions — but how can that be?. If you look at the quote above, you’ll notice a small difference of pips between the two quoted currencies (in the 4th decimal place); the difference in prices here equals 5 pips.
This 5 pip difference in price is known as the spread, and the spread represents the difference between the ASK and BID is called spread. This spread represents brokerage service costs and replaces transactions fees for Forex traders.The spread is how the broker makes his money and works similarly to the bid/ask in stock trading.
Not all spreads are created equal. The spread differs between brokers and sometimes even the time of day can cause volume to be light and the spread to subsequently increase for some brokers. There are several factors that influence the size of the bid-ask spread, with the most important being currency liquidity. Popular currency pairs are traded with the lowest spreads while rare pairs might have as high as a “dozen pip” spread.
The next factor that can influence the bid/ask spread is the amount of a deal. Middle size Forex trading deals are executed on quotations with standard tight spreads, but extreme deals – including ones that are very small along with ones that are very large – are quoted with larger spreads due to the risks taken by brokers.
During volatile market times, bid-ask spreads are wider than during quiet market conditions. Even the status of a trader can influence the spread as the biggest traders can enjoy personal discounts. It is fortunate that you are trading during a time of high broker competition, which means as brokers attempt to attract customers, their spreads are usually at or near their lowest levels.
As a trader, you should always pay attention to spread management, because good trading can only happen when all of the market conditions are considered. It’s important to realize that because spreads may change at any time, your spread management strategy should remain flexible enough to adjust to any market movement.
To help you understand more about pip spreads, here are the types you will routinely see as you trade the Forex market:
- Fixed spread – difference between ASK and BID is kept constant and does not depend on market conditions. Fixed spreads are set by dealing companies for automatically traded accounts.
- Fixed spread with an extension – a certain part of a spread is predetermined and another part may be adjusted by a dealer according to market.
Variable spread – fluctuates in correlation with market conditions. Generally variable spread is low during times of market inactivity (approximately 1-2 pips), but during a volatile market can actually widen to as much as 40-50 pips. This type of spread is closer to real market but brings higher uncertainty to trading and makes the creation of an effective strategy more difficult.