Spreads and Pips

The difference between the bid price and the ask price in a forex quote is normally called the spread. In the previous example: USD/CAD = 1.3495/99, the spread is 0.0004, or 4 pips. Pips, or points, is the common name used to refer to incremental changes in a forex quote – a change from 1.3495 to 1.3496 would equal one pip. Although these currency movements may seem small, due to leverage used in the forex market, small changes can result in large profits or losses. (Learn how brokerages make some of their profits in How is spread calculated when trading in the forex market?)

With the major currency pairs such as the EUR/USD, USD/CAD, GBP/USD, one pip would be equal to 0.0001. However, if you take a look at a USD/JPY quote you'll notice the pair only goes to two decimal places, so one pip would be 0.01. So, in general, a pip represents the last decimal place in the quote.

Currency Quote Overview

USD/CAD = 1.3495/99

Base Currency

Currency to the left (USD)

Quote/Counter Currency

Currency to the right (CAD)

Bid Price

1.3495

Price for which the market maker will buy the base currency. Bid is always smaller than ask.

Ask Price

1.3499

Price for which the market maker will sell the base currency.

Pip

One point move, in USD/CAD it is .0001 and 1 point change would be from 1.3495 to 1.3496

The pip/point is the smallest movement a price can make.

Spread

Spread in this case is 4 pips/points, or the difference between bid and ask price (1.3499-1.3495).

Lots

Similar to how most stocks trade in lots to facilitate trading, currencies are also traded in lots – $100,000 is typically the standard lot. There are also smaller lots with a size of $10,000 called mini-lots, or $1,000 called micro lots. To many, these may seem like large amounts but because currencies only move in small increments, only a few pips at a time, a larger amount of currency is needed to generate any sizable profits or losses. (For more on mini lots, see Forex Minis Shrink Risk Exposure.)

Direct Currency Quote vs. Indirect Currency Quote

You can quote a currency pair in two ways, either directly or indirectly. A direct currency quote is simply a foreign exchange quote where the foreign currency is the base currency; an indirect quote is a currency pair in which the domestic currency is the base currency. For example, if you're in Canada and the Canadian dollar is the domestic currency, a direct quotation would take the form of a variable amount of the domestic currency for a fixed amount of the foreign currency. A Canadian bank giving a quote of "C$1.35 per US$1" would be a direct quote. Conversely, an indirect quote fixes the domestic currency and varies the foreign currency. In the same example, if the Canadian bank gave a quote of "C$1=US$0.74" it would be an indirect quote.

Cross Currency

A currency quote given without the U.S. dollar as part of the currency pair is called a cross currency quote. Common cross currency pairs include the EUR/CHF, EUR/GBP and EUR/JPY. Although having cross currencies increases the amount of choice for the investor in the forex market, cross currencies are not as popular as ones that have the U.S. dollar as a component of the currency pair. (For more on cross currency, see Make The Currency Cross Your Boss)

Now that you know more about reading and interpreting a forex quote, in the next section we'll look briefly at the economics and fundamentals behind forex trades and what economic indicators a new trader should become familiar with and be able to interpret.

Forex Brokers

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