Pip spread

1. Pip Spread: A Comprehensive Guide for Beginner Traders

The "pip spread" is a fundamental concept in foreign exchange (Forex) trading, and understanding it is crucial for any aspiring trader. While often overlooked by beginners, the pip spread directly impacts profitability. This article will delve deep into the intricacies of the pip spread, covering its definition, calculation, types, significance, how it relates to trading costs, and strategies to minimize its impact. We will also explore how it interacts with Leverage and Risk Management.

What is a Pip?

Before understanding the pip spread, it’s essential to define a “pip” itself. “Pip” stands for “percentage in point.” It is the smallest incremental move that an exchange rate can make. In most currency pairs, a pip is equal to 0.0001. For example, if the EUR/USD exchange rate moves from 1.1000 to 1.1001, that's a one-pip increase.

However, some currency pairs (like those involving the Japanese Yen – JPY) are quoted to only two decimal places. In these cases, a pip is equal to 0.01. So, a move from 110.00 to 110.01 JPY/USD is a one-pip increase.

Understanding which currency pair uses which pip definition is fundamental. Most trading platforms automatically calculate pips and profit/loss in pips, but knowing the underlying principle is vital. Refer to Technical Analysis for more details on interpreting price movements.

Defining the Pip Spread

The pip spread is the difference between the ask price and the bid price of a currency pair.

• **Ask Price:** The price at which a broker is willing to *sell* you the base currency.
• **Bid Price:** The price at which a broker is willing to *buy* the base currency from you.

The spread is essentially the broker’s commission. Instead of charging a direct commission fee, brokers earn money from the spread.

Let's illustrate with an example. Suppose the EUR/USD currency pair is quoted as:

• Bid: 1.1000
• Ask: 1.1002

The spread is 1.1002 - 1.1000 = 0.0002 or 2 pips.

When you *buy* (go long) EUR/USD at the ask price (1.1002), you immediately have a negative “profit” of -2 pips. You'll need the price to rise by at least 2 pips *before* you start making a real profit.

Conversely, when you *sell* (go short) EUR/USD at the bid price (1.1000), you immediately have a negative “profit” of -2 pips. The price needs to fall by at least 2 pips before you are profitable.

Types of Pip Spreads

Pip spreads aren't uniform. They vary based on several factors and can be categorized as follows:

• **Fixed Spreads:** These spreads remain constant regardless of market volatility. They are typically offered by brokers with a dealing desk model. Fixed spreads offer predictability but are generally wider than variable spreads.
• **Variable (Floating) Spreads:** These spreads fluctuate based on market conditions, volatility, and liquidity. They are common with brokers offering direct market access (DMA) or electronic communication networks (ECN). Variable spreads can be tighter during periods of high liquidity, but widen during news events or low liquidity, increasing trading costs. Understanding Market Volatility is key to anticipating spread changes.
• **Zero Spreads:** Some brokers offer zero spreads on certain currency pairs, meaning the bid and ask prices are the same. However, they typically charge a commission per trade. This is common in ECN accounts.
• **Raw Spreads:** These are the tightest possible spreads, reflecting the interbank market. They are usually only available to institutional traders or through ECN accounts with a commission.

Factors Influencing Pip Spread

Several factors influence the size of the pip spread:

• **Liquidity:** Higher liquidity generally leads to tighter spreads. Major currency pairs (EUR/USD, USD/JPY, GBP/USD) have the highest liquidity and therefore the tightest spreads.
• **Volatility:** Increased volatility typically widens spreads as brokers increase their risk buffer.
• **Time of Day:** Spreads tend to widen during periods of low trading volume, such as overnight or during holidays. The Trading Session overlap (London/New York) usually offers the tightest spreads.
• **Broker Type:** Different brokers have different pricing models and spreads. Broker Selection is a crucial part of a trading plan.
• **News Events:** Major economic news releases can cause significant price fluctuations and widen spreads dramatically.
• **Currency Pair:** Exotic currency pairs (those not frequently traded) generally have wider spreads than major pairs.

The Significance of the Pip Spread

The pip spread is a critical factor in assessing trading costs and profitability. Here's why:

• **Impact on Profitability:** The spread directly reduces your potential profit. You need the price to move past the spread *before* you begin to profit. For short-term traders, particularly scalpers who aim for small profits, the spread can significantly impact their results.
• **Cost of Trading:** The spread is the broker's commission. It's an inherent cost of trading that must be factored into your trading strategy.
• **Strategy Selection:** The spread influences the types of trading strategies that are viable. Scalping requires tight spreads, while longer-term strategies are less sensitive to spread fluctuations. Consider your chosen Trading Strategy when evaluating spreads.
• **Account Type:** Different account types (standard, ECN, micro) often have different spread structures.
• **Risk-Reward Ratio:** The spread effectively reduces your risk-reward ratio. A wider spread means you need a larger price movement to achieve a favorable risk-reward.

Calculating Profit and Loss with the Pip Spread

Understanding how to calculate profit and loss considering the spread is vital.

• • Example:**

Let's assume you buy 1 lot (100,000 units) of EUR/USD at 1.1002 (the ask price) and sell it later at 1.1010. The spread was 2 pips (1.1002 - 1.1000).

1. **Initial Loss:** You started with a loss of 2 pips due to the spread. 2. **Total Pip Movement:** The price moved 8 pips (1.1010 - 1.1002). 3. **Net Profit:** 8 pips (total movement) - 2 pips (spread) = 6 pips profit. 4. **Profit in Currency:** 6 pips x $10 per pip (standard lot size) = $60 profit.

(Note: the $10 per pip value is approximate and can vary based on the currency pair and lot size.)

The formula for calculating profit/loss is:

(Exit Price – Entry Price) – (Spread) x Lot Size x Pip Value

Minimizing the Impact of the Pip Spread

While you can't eliminate the spread, you can minimize its impact on your trading:

• **Choose a Broker with Tight Spreads:** Research and compare brokers to find those offering competitive spreads for the currency pairs you trade.
• **Trade During High Liquidity:** Trade during peak trading hours (London/New York overlap) when spreads are typically tighter.
• **Avoid Trading During News Events:** Spreads widen significantly during major news releases. Consider avoiding trading around these times, or use wider stop-losses to account for increased volatility. Using a Economic Calendar is essential.
• **Consider an ECN Account:** ECN accounts often offer tighter spreads and direct market access, but usually involve a commission.
• **Use Appropriate Lot Sizes:** Adjust your lot size to account for the spread. Smaller lot sizes reduce the absolute dollar amount lost to the spread.
• **Longer-Term Trading:** If you’re a longer-term trader, the spread will have a less significant impact on your overall profitability.
• **Implement Spread Monitoring Tools:** Some trading platforms offer tools to monitor spreads in real-time.
• **Utilize Limit Orders:** Instead of market orders, use limit orders to potentially buy at a lower price (closer to the bid) or sell at a higher price (closer to the ask).

Pip Spread and Other Trading Concepts

The pip spread interacts with several other important trading concepts:

• **Margin**: The spread affects the amount of margin required for a trade, as it’s part of the initial cost.
• **Stop-Loss Orders**: You must account for the spread when setting stop-loss orders to avoid being stopped out prematurely. A stop-loss placed too close to the entry price, relative to the spread, could be triggered by normal price fluctuations.
• **Take-Profit Orders**: Similarly, consider the spread when setting take-profit orders.
• **Position Sizing**: The spread should be factored into your position sizing calculations.
• **Trading Psychology**: Understanding the spread can reduce frustration and improve your trading psychology, as you'll have a more realistic expectation of profit potential.
• **Technical Indicators**: Consider how the spread might affect the signals generated by your chosen Moving Averages, Relative Strength Index (RSI), MACD, Bollinger Bands, Fibonacci Retracements, Ichimoku Cloud, Elliott Wave Theory, Candlestick Patterns, Support and Resistance Levels, Trend Lines, and other indicators.
• **Chart Patterns**: Analyze chart patterns in conjunction with spread awareness.
• **Day Trading**: Day traders are particularly sensitive to spreads due to their short holding times.
• **Swing Trading**: Swing traders are less affected by spreads but still need to be aware of them.
• **Arbitrage**: Skilled traders may attempt to profit from spread discrepancies between different brokers or exchanges (arbitrage).
• **Hedging**: Hedging strategies can be used to mitigate the risk associated with spread fluctuations.
• **Correlation Trading**: Understanding spread relationships between correlated currency pairs can inform trading decisions.
• **Algorithmic Trading**: Algorithmic trading systems can be programmed to consider spreads when executing trades.
• **Backtesting**: When backtesting trading strategies, it’s crucial to include realistic spread data to obtain accurate results.
• **Fundamental Analysis**: While fundamental analysis focuses on economic factors, understanding the impact of these factors on liquidity and volatility (and thus the spread) is important.
• **Elliott Wave Analysis**: The spread can influence the timing and confirmation of Elliott Wave patterns.

Conclusion

The pip spread is a fundamental aspect of Forex trading that beginners often underestimate. By understanding its definition, types, influencing factors, and impact on profitability, traders can make more informed decisions and develop strategies to minimize its negative effects. Paying attention to the spread is not just about saving money; it’s about maximizing your potential for success in the Forex market.

Start Trading Now

Sign up at IQ Option (Minimum deposit $10) Open an account at Pocket Option (Minimum deposit $5)

Join Our Community

Subscribe to our Telegram channel @strategybin to receive: ✓ Daily trading signals ✓ Exclusive strategy analysis ✓ Market trend alerts ✓ Educational materials for beginners