What are Pips ?

To understand pips on the forex market you must understand how the market works. If you are new to forex trading there are many worthwhile, free offers and software online to help you learn and practise before risking your money.

Forex is an abbreviation of foreign exchange, the buying and selling of one foreign currency for another. As one currency strengthens so another weakens and knowing when to buy and sell is how money is made on the Forex markets. The Forex market is similar to the buying and selling of stocks but in many ways it is much more difficult. On the stock market you may spot a company that has potential, buy shares and hopefully make a profit, but on the money market there may be long term trends where a currency strengthens and weakens, but much of the trading is based upon daily fluctuations that change by the minute.

A pip is the smallest unit of price that is traded for a currency. Most currencies are traded to four decimal points, so that a pip is 0.0001 or 1/100 of a cent. This may seem a minuscule amount until you realise that on a standard trade of $100,000 that is $10. The exception to the four decimal points is the Japanese yen which is normally traded to two decimal points.

Obviously if you are buying a currency you must also be selling another and therefore prices are always quoted in pairs, the USD/EUR being the most active. The more active a pair the narrower the difference between the bid/ask price is likely to be, with a possible spread of just two pips for the most actively traded.
Unlike the stock market there are no broker fees to pay, but as each trade involves both selling one currency and buying another, the difference in the spread is the cost of the transaction and must be taken into account when calculating profit. Therefore, as a buyer, the pip spread is very important to you. When you buy you have to accept an immediate loss. The value of the currency you have bought must rise by the extent of the pip spread before you break even and the value rise again to make a profit. The lower the spread the easier it is to make a profit.
Active markets tend to have a lower pip spread, for example 2-3 pips. Currencies that are bought and sold less frequently may have a far higher spread. However, before you go to a broker offering a very narrow spread, do check that they are reputable. You should also remember that pip spreads are not guaranteed, they can change if the market fluctuates widely. It is wise to check a broker's spread policy before trading.

Leverage Risks

As we mentioned above, the best trader is he who can detach himself from his emotions during his trading activity: one can have as much excitement and joy as he desires while enjoying the fruits of his achievements, but during trading itself, the heart should beat softly, and the brain should be in charge. Needless to say, a high-risk, all-or-nothing environment where any slight mistake can wipe out the trader's capital is not the environment that is conducive to creating such a mentality. Mistakes will inevitably happen during trading; neither man nor machine is capable of predicting every movement of the market precisely. To ensure that the mistakes that occur do not eliminate your capital, your self-esteem, and your chance of learning from your errors, do not over leverage.

High leverage works against the speculator by increasing the stakes and making the heart beat faster. No one jumps in his seat over the loss of a couple of dollars through which lessons are learned and mistakes recognized. But as potential losses increase, the beginner will have no time to focus on the lessons from his deficiencies, but instead will agonize over his stupidity at having risked so much money in a bet that didn't possess much chance of success anyway. And there begins the vicious spiral of fear, and losses which can eventually ruin a good man's livelihood.

But if the reader is afraid of the large holes that leverage can open in his pockets, he should also keep in mind that there's nothing related to the forex market per se that is dangerous and harmful. Forex is perhaps the safest of all market, since in general the prices move very slowly, and unlike in the stock market, the wipe-out of an unleveraged account is almost impossible: let us remember that nations do not go bankrupt, and currencies don't go to zero in general. But because many people see forex as a get-rich-quick scheme, and expect nonsensical levels of leverage to work for them, more people fail in this market than those who succeed.

Remember, if you can't create great returns at low leverage, there's absolutely no reason to expect to do so on high leverage, and every reason to expect massive losses instead.

Market Participants

Unlike the equity market - where investors often only trade with institutional investors (such as mutual funds) or other individual investors - there are additional participants that trade on the Forex market for entirely different reasons than those on the equity market. Therefore, it is important to identify and understand the functions and motivations of the main players of the Forex market.

Governments and Central Banks
Arguably, some of the most influential participants involved with currency exchange are the central banks and federal governments. In most countries, the central bank is an extension of the government and conducts its policy in tandem with the government. However, some governments feel that a more independent central bank would be more effective in balancing the goals of curbing inflation and keeping interest rates low, which tends to increase economic growth. Regardless of the degree of independence that a central bank possesses, government representatives typically have regular consultations with central bank representatives to discuss monetary policy. Thus, central banks and governments are usually on the same page when it comes to monetary policy.

Central banks are often involved in manipulating reserve volumes in order to meet certain economic goals. For example, ever since pegging its currency (the Yuan) to the U.S. dollar, China has been buying up millions of dollars worth of U.S. treasury bills in order to keep the Yuan at its target exchange rate. Central banks use the foreign exchange market to adjust their reserve volumes. With extremely deep pockets, they yield significant influence on the currency markets.

Banks and Other Financial Institutions
In addition to central banks and governments, some of the largest participants involved with Forex transactions are banks. Most individuals who need foreign currency for small-scale transactions deal with neighborhood banks. However, individual transactions pale in comparison to the volumes that are traded in the interbank market.

The interbank market is the market through which large banks transact with each other and determine the currency price that individual traders see on their trading platforms. These banks transact with each other on electronic brokering systems that are based upon credit. Only banks that have credit relationships with each other can engage in transactions. The larger the bank, the more credit relationships it has and the better the pricing it can access for its customers.

Banks, in general, act as dealers in the sense that they are willing to buy/sell a currency at the bid/ask price. One way that banks make money on the Forex market is by exchanging currency at a premium to the price they paid to obtain it. Since the Forex market is a decentralized market, it is common to see different banks with slightly different exchange rates for the same currency.

Hedgers
Some of the biggest clients of these banks are businesses that deal with international transactions. Whether a business is selling to an international client or buying from an international supplier, it will need to deal with the volatility of fluctuating currencies.

If there is one thing that management (and shareholders) detests, it is uncertainty. Having to deal with foreign-exchange risk is a big problem for many multinationals. For example, suppose that a German company orders some equipment from a Japanese manufacturer to be paid in yen one year from now. Since the exchange rate can fluctuate wildly over an entire year, the German company has no way of knowing whether it will end up paying more Euros at the time of delivery.

One choice that a business can make to reduce the uncertainty of foreign-exchange risk is to go into the spot market and make an immediate transaction for the foreign currency that they need.

Unfortunately, businesses may not have enough cash on hand to make spot transactions or may not want to hold massive amounts of foreign currency for long periods of time. Therefore, businesses quite frequently employ hedging strategies in order to lock in a specific exchange rate for the future or to remove all sources of exchange-rate risk for that transaction.

For example, if a European company wants to import steel from the U.S., it would have to pay in U.S. dollars. If the price of the euro falls against the dollar before payment is made, the European company will realize a financial loss. As such, it could enter into a contract that locked in the current exchange rate to eliminate the risk of dealing in U.S. dollars. These contracts could be either forwards or futures contracts.

Speculators
Another class of market participants involved with foreign exchange-related transactions is speculators. Rather than hedging against movement in exchange rates or exchanging currency to fund international transactions, speculators attempt to make money by taking advantage of fluctuating exchange-rate levels.

Some of the largest and most controversial speculators on the Forex market are hedge funds, which are essentially employ unconventional investment strategies in order to reap large returns. Given that they can place such massive bets, they can have a major effect on a country’s currency and economy.

Reading Quotes

One of the biggest sources of confusion for those new to the currency market is the standard for quoting currencies. In this section, we'll go over currency quotations and how they work in currency pair trades.

When a currency is quoted, it is done in relation to another currency, so that the value of one is reflected through the value of another. Therefore, if you are trying to determine the exchange rate between the U.S. dollar (USD) and the Japanese yen (JPY), the quote would look like this:

USD/JPY = 105.25

This is referred to as a currency pair. The currency to the left of the slash is the base currency, while the currency on the right is called the quote or counter currency. The base currency (in this case, the U.S. dollar) is always equal to one unit (in this case, 1 USD), and the quoted currency (in this case, the Japanese yen) is what that one base unit is equivalent to in the other currency. The quote means that US$1 = 105.25 Japanese yen. In other words, US$1 can buy 105.25 Japanese yen.

Direct Quote vs. Indirect Quote
There are two ways to quote a currency pair, either directly or indirectly. A direct quote is simply a currency pair in which the domestic currency is the base currency; while an indirect quote, is a currency pair where the domestic currency is the quoted currency. So if you were looking at the Canadian dollar as the domestic currency and U.S. dollar as the foreign currency, a direct quote would be CAD/USD, while an indirect quote would be USD/CAD. The direct quote varies the foreign currency, and the quoted, or domestic currency, remains fixed at one unit. In the indirect quote, on the other hand, the domestic currency is variable and the foreign currency is fixed at one unit.

For example, if Canada is the domestic currency, a direct quote would be 0.85 CAD/USD, which means with C$1, you can purchase US$0.85. The indirect quote for this would be the inverse (1/0.85), which is 1.18 USD/CAD and means that USD$1 will purchase C$1.18.

In the Forex spot market, most currencies are traded against the U.S. dollar, and the U.S. dollar is frequently the base currency in the currency pair. This would apply to the above USD/JPY currency pair, which indicates that US$1 is equal to 119.50 Japanese yen.

However, not all currencies have the U.S. dollar as the base. The Queen's currencies - those currencies that historically have had a tie with Britain, such as the British pound, Australian Dollar and New Zealand dollar - are all quoted as the base currency against the U.S. dollar. The Euro, which is relatively new, is quoted the same way as well. This is why the EUR/USD quote is given as 1.55, for example, because it means that one euro is the equivalent of 1.55 U.S. dollars.

Most currency exchange rates are quoted out to four digits after the decimal place, with the exception of the Japanese yen (JPY), which is quoted out to two decimal places.

Bid and Ask

As with most trading in the financial markets, when you are trading a currency pair there is a bid price (buy) and an ask price (sell). Again, these are in relation to the base currency. When buying a currency pair (going long), the ask price refers to the amount of quoted currency that has to be paid in order to buy one unit of the base currency, or how much the market will sell one unit of the base currency for in relation to the quoted currency.

The bid price is used when selling a currency pair (going short) and reflects how much of the quoted currency will be obtained when selling one unit of the base currency, or how much the market will pay for the quoted currency in relation to the base currency.

The quote before the slash is the bid price, and the two digits after the slash represent the ask price (only the last two digits of the full price are typically quoted). Note that the bid price is always smaller than the ask price. Let's look at an example:

USD/CAD = 1.1915/1.1920
BID = 1.1915
ASK = 1.1920

If you want to buy this currency pair, this means that you intend to buy the base currency and are therefore looking at the ask price to see how much (in Canadian dollars) the market will charge for U.S. dollars. According to the ask price, you can buy one U.S. dollar with 1.1920 Canadian dollars.

However, in order to sell this currency pair, or sell the base currency in exchange for the quoted currency, you would look at the bid price. It tells you that the market will buy US$1 base currency (you will be selling the market the base currency) for a price equivalent to 1.1915 Canadian dollars, which is the quoted currency.

Whichever currency is quoted first (the base currency) is always the one in which the transaction is being conducted. You either buy or sell the base currency. Depending on what currency you want to use to buy or sell the base with, you refer to the corresponding currency pair spot exchange rate to determine the price.

Avoiding/lowering risk when trading Forex

Trade like a technical analyst. Understanding the fundamentals behind an investment also requires understanding the technical analysis method. When your fundamental and technical signals point to the same direction, you have a good chance to have a successful trade, especially with good money management skills. Use simple support and resistance technical analysis, Fibonacci Retracement and reversal days. Be disciplined. Create a position and understand your reasons for having that position, and establish stop loss and profit taking levels. Discipline includes hitting your stops and not following the temptation to stay with a losing position that has gone through your stop/loss level. When you buy, buy high. When you sell, sell higher. Similarly, when you sell, sell low. When you buy, buy lower. Rule of thumb: In a bull market, be long or neutral - in a bear market, be short or neutral. If you forget this rule and trade against the trend, you will usually cause yourself to suffer psychological worries, and frequently, losses. And never add to a losing position.

Hedging in the Forex Market

Just like in the stock market, forex investors often use a strategy called hedging to decrease some of the risk associated with trading. Many people think of hedging as buying an insurance policy for their currency position, and it acts in much the same way. By using investment instruments known as derivatives, forex traders can rest easy knowing that any losses will be covered by the backup plan.

One type of derivative that many forex traders use to hedge a position is a futures contract, which is an agreement to exchange one currency for another at a specified date in the future at the price on the last closing date. Currency futures are bought and sold on a market just like any other instrument such as stocks or currencies, and are a great way to hedge against changing currency exchange rates. For example, say you used dollars to take a long position in euros, but you are a little worried that the price of euros will fall relative to the dollar. One thing you could do is take out a futures contract on dollars using euros. As external factors affect the price of currencies, the price of futures contracts rise and fall as well, allowing your euros-to-dollars contract to counteract your long position in euros. If the euro weakens, the futures contract price rises, and vice-versa, so you have therefore eliminated the risk from your currency investment.

Another form of hedging in the forex market that is practiced regularly is done by businesses that deal internationally. A company that has many customers in Europe may be concerned that a weakening euro would cost it money in the long run, as the original price quoted in euros wouldn’t translate into as many dollars going forward. By taking a long position in dollars using euros, the company would make just as much money in the forex market as it lost due to the fall in the euro’s value. Likewise, if it lost money in the forex market due to a fall in the value of the dollar, the company would make up for it in increased profits due to the greater value of the euros it is bringing in while selling its products. The position in the forex market has effectively neutralized any threat the company may have faced due to a weakening euro. This type of hedging can take several other forms, including futures contracts and options.

Traditional forex options are derivatives that allow the buyer to purchase an amount of currency from another trader for a set price, and make a great hedging tool. Again, these are instruments that are traded on the open market, and the investor is under no obligation to follow through with the option. But sometimes following through is a good way to negate a currency loss. For example, a person who bought an allotment of yen with dollars wants to hedge against the price of yen falling relative to the dollar. What he can do is buy an option to purchase the same amount of dollars using yen at the price for which he originally bought the yen. Since options only cost a small fraction of their denomination, this investor has just taken out an insurance policy on his long yen position for a relatively small amount of money. If the price of yen rises, then he has made a profit on his long position and he is just out the money he used to buy the option. But, if the dollar strengthens relative to the yen, he can always wait and exercise his option, buying additional yen at the now reduced rate as specified by the currency option. Thus, for a small option price, he has negated the loss he incurred when the dollar strengthened and the yen weakened.

By using instruments such as futures contracts and options, traders can hedge their currency positions for a fraction of what they paid for their original investment. Also, businesses operating internationally often hedge in the forex market as well, taking currency positions to offset any losses caused by fluctuation in exchange rates. Hedging is a powerful tool that serves well those who take the time to use it.