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.