Before you even start placing a trade, you should first get a proper education and get familiarized with the basic terminology of Forex trading. A Pip is a term that we often run across in contexts involving Forex trading and is one of the first things you need to learn to get a proper understanding of how the Forex market really works.
Currencies Are What We Trade
All currencies are quoted in pairs where each currency is abbreviated into three letters. The first two letters represent the country, and the third represents the currency. These are the most common currency pairs traded.
- US Dollar abbreviation is: USD
- Australian Dollar abbreviation is: AUD
- Euros abbreviation is: EUR
- Japanese Yen abbreviation is: JPY
- Swiss Franc abbreviation is: CHF
- British Pound abbreviation is: GBP
What are Quotes?
When you’re dealing in the Forex market, you’re buying or selling one currency against another currency, which is the reason why currencies are quoted in pairs. A Forex quote will always be composed of two currencies.
The first currency listed on the left is the Base currency, while the currency listed on the right is the Quote currency
A Forex quote will always involve two currencies; where the currency on the left represents the base currency while the currency on the right represents the counter currency which is also referred to as the quote currency.
Example: If the AUD/USD is 0.7500, it means it takes 0.7500 US dollars to buy one Australian Dollar. The value of the Base currency is always 1.
If the AUD/USD exchange rate goes up, it means the Base currency has strengthened, and the Quote currency has weakened. If the AUD/USD exchange goes down, it means the Base currency has weakened while the Quote currency has strengthened.
What is Pip?
A Pip stands for “Percentage in Point” and represents a unit of price change in any given currency pair. When the value of a currency pair changes by a certain number of pips, then it means the value of the currency pair has changed by that number of units.
In other words, a pip represents the smallest price change a currency pair can make.
If there is an increase by a certain number of pips, there’s actually an increase in the value of that currency pair. Conversely, if there is a decrease by a certain number of pips, then there is also a decrease in the value of that currency pair.
Most currency pairs are valued till the 4th decimal place. In this case, one pip is one unit of this 4th decimal place, which is 1/100th of a percent. Occasionally, some brokers will quote you prices in five decimal places, where the 5th decimal is actually called a pipet or fractional pip.
It’s easier to talk in terms of pips, which are whole numbers as opposed to decimal places or fractions.
Example: If the AUD/USD exchange rate is currently valued at 0.7515, and if tomorrow the exchange rate is at 0.7450, therefore there was a fall of 0.0065 (0.7515 – 0.740). If a change of 0.0001 is 1 pip, then a change of 0.0065 represents 65 pips. Therefore, we can say the AUD/USD exchange rate fell by 65 pips. Much easier.
Not all currency pairs are priced at the 4th decimal place, an example of this being the Japanese Yen, which is priced at the second decimal place. So, when we describe the currency pairs in terms of pips, we’re just talking about a unit of conversion.
What are Spreads?
When you pull up your trading account and you pull up the quote window. Usually, on the right side you will find the buy price or the Ask price, and on the left side is the sell price or the Bid price. This is the two-price quotation system or the two-way quote system that all currency pairs are using.
The spread is the difference between the price at which you’re allowed to buy (Ask) and the price at which you’re allowed to sell (Bid). In other words, the amount of pips between the bidding price and asking price is the spread. The size of the bid-ask spread is a measurement of the size of the transaction cost.
Example: If the current bid price of the AUD/USD is 0.7610 and the current offer price is 0.7611, this means the difference between those prices 1 pip is the spread.
The spread is the way your Forex broker makes money and is also the cost of doing business that you need to pay as a trader. By charging a spread, and in some cases by charging a commission, the Forex brokers make a profit and continue to offer their services. For more on calculating profit and pips, read our article here.
Forex Direct Quote vs. Indirect Quote
We can distinguish two types of currency quotes: the direct quote and the indirect quote system. If the second currency or the quoted currency of a currency pair is the domestic currency, then we’re dealing with a direct quotation system.
If the first currency or the base currency of a currency pair is the domestic currency, then we’re dealing with an indirect quotation system.
For example, if we’re looking at the Australian Dollar as being the domestic currency and the US Dollar as the foreign currency then:
- A direct quote would be USD/AUD
- While an indirect quote would be AUD/USD.
For example, if the Australian Dollar is the domestic currency, an indirect quote would be 0.7800 AUD/USD which means that with 1 AUD, you can purchase 0.78 USD. The direct quote (USD/AUD) will be the inverse (1/0.7800) or 1.2820 USD/AUD which means that with 1 USD you can purchase 1.2820 AUD.
Forex Cross Currency
A Forex cross currency is a currency pair traded in Forex that doesn’t include the US Dollar in the quotation system. The most popular currency crosses include the following pairs: EUR/GBP, EUR/JPY, and GBP/JPY.
The cross currency pairs were released to help individuals who wanted to exchange their money directly without having to first convert it to USD. When trading these crosses take note that they are less liquid and more volatile, which means that you can also make more money trading these pairs.