The essence of pip in forex trading: A complete guide from spreads to cost calculation

Traders’ Must-Know: The Meaning of Pip and Practical Application of Spreads

Before trading in the forex market, understanding the pip is crucial for controlling trading risks. In simple terms, a pip is the smallest unit of price movement for a currency pair. For example, if EUR/USD moves from 1.1234 to 1.1235, this 0.0001 change represents 1 pip.

For most currency pairs, a pip is reflected in the fourth decimal place. However, currency pairs related to the Japanese Yen are a bit special — for USD/JPY, one pip corresponds to the second decimal place. This detail significantly impacts profit and loss calculations.

It’s important to note that forex trading typically involves leverage, so even a movement of 1 pip can result in substantial profit or loss in actual trading.

How is the value of a pip calculated? Three key factors determine everything

The actual value of each pip depends on three elements: the currency pair being traded, the trading size, and the current exchange rate. These three factors work together, making even tiny price fluctuations have a significant impact on funds.

For example, USD/CAD: If a trader buys 50,000 USD/CAD at 1.3050 and closes with a profit of 50 pips, calculating the profit involves three steps:

First, determine the value of each pip in the quote currency (CAD): 50,000 × 0.0001 = 5 CAD/pip

Second, convert this to the base currency (USD): 5 ÷ 1.3050 ≈ 3.83 USD/pip

Finally, calculate the total profit: 50 × 3.83 = 191.5 USD

In the case of USD/JPY: A trader buys 50,000 USD/JPY at 123.456 and closes when the price drops to 123.256, incurring a loss of 20 pips. The calculation process is similar — first, find the value of JPY per pip (50,000 × 0.01 = 500 JPY/pip), then convert to USD (500 ÷ 123.256 ≈ 4.057 USD/pip), and finally, the loss amount is -20 × 4.057 = 81.14 USD.

Spread: The broker’s operating mechanism and the trader’s actual cost

When trading forex, you will see two different prices — the Ask (buy price) and Bid (sell price). The difference between these two prices is called the spread, which is the trader’s actual cost to enter a trade.

From the broker’s perspective, the spread is their main income source in a no-commission model: they buy currency from liquidity providers at a lower price and sell to traders at a higher price; simultaneously, they buy the trader’s currency at a lower price. This buy-sell difference is the broker’s profit.

Two types of forex spreads and their advantages and disadvantages

According to the broker’s operating model, spreads are divided into two main types:

Fixed spread provided by market maker brokers. Regardless of market volatility, the spread remains constant. This model requires less capital, makes trading costs more predictable, and is suitable for small capital traders. However, the downside is that during intense market fluctuations, brokers cannot adjust the spread to respond to market conditions, which can lead to slippage — the executed price differs from the intended order price.

Floating spread comes from non-market maker brokers, who obtain quotes from multiple liquidity providers and pass them directly to traders. Floating spreads offer higher pricing transparency, and traders have the opportunity to get better quotes from multiple providers. However, for frequent traders, rapidly widening spreads can quickly eat into profits. Typically, during major economic data releases or when market liquidity drops, floating spreads will widen significantly.

How to calculate spread costs in practical trading?

To accurately calculate the trading cost caused by the spread, you need to understand two factors: the value of each pip and the trading lot size.

For example, in EUR/USD, if the buy price is 1.04111 and the sell price is 1.04103, the spread is 0.8 pips. If you buy 1 mini lot (10,000 units) and close immediately, with each pip worth 1 USD, then the spread cost for this trade is 0.8 × 1 = 0.8 USD.

If you increase the position to 5 mini lots, the same 0.8 pip spread will result in 0.8 × 5 = 4 USD in costs. This shows that the larger the trading size, the greater the absolute spread cost.

Therefore, understanding the precise meaning of pip, mastering spread calculations, and choosing the appropriate spread type based on your capital are essential lessons in forex trading to control costs and optimize returns.