In the last lesson we covered everything you need to know about currency pairs: from how to read them, why they exist, to which are the most commonly traded. In case you need a refresher, we suggest that you reread this lesson before continuing.
Otherwise you are now ready to learn about exchange rates and pips. Yipee!
The exchange rate is quite literally the value of a currency for the purpose of converting it to another.
In the last chapter we explored how currency pairs are structured as a base currency and a quote currency.
Let’s take an example of EUR/USD with an exchange rate of 1.06. This means that to buy 1 unit of euros (1 euro) you will have to spend 1.06 USD. EUR is the base currency (they one you want to buy) and USD is the quote currency (the one you want to sell).
This also works in the other direction. Let say you want to know the cost of buying 1 USD using EUR. In this case the exchange rate is 0.96, or 0.96 euros buys you 1 USD.
Easy right? It is, but when it comes to currency trading, it gets a bit more complicated and is worth digging a bit deeper.
Breaking down the exchange rate
If you have been trading on https://www.bestonlinetrading.co.uk, you may have noticed that the exchange rates are quoted with 5 decimal points. This is because, traders do not just take into account fluctuations in the amount of cents in a trade, but also of fractions of a cent!
I know what you are thinking… “Stop. Wait. You’re just talking nonsense now! I mean, a cent is hardly worth a thing… Why on earth would I care about fractions of a cent?”
Well, that may seem to be the case, but is not at all true. As we will see in later examples, when trading large amounts of currency, a fraction of a cent can actually be worth a TON of money. But before we get there, bear with me and keep reading…
Let’s go back to our EUR/USD example. Before, we said the exchange rate was 1.06 USD for 1 EUR. However, a trader will read it more like this: EUR/USD = 1.06814, or 1 euro = 1 dollar, 6 cents, 8 10ths of a cent, 1 pip, and 4 pipettes. The key here are the pips and pipettes.
A pip is the abbreviation of price interest point, and is the equivalent of 1/100th of a cent.
The large majority of currency pairs are quoted down to the pip, or fourth decimal place. The reason for this is that currencies are generally traded in such large amounts, that even a fractional change in the exchange rate can mean a huge change in value.
To illustrate this, let’s take a look at an example using the above mentioned exchange rate of EUR/USD = 1.06814. Let’s say you make a trade using 100,000 USD, and buy Euros.
You hold on to the Euros for a while and the EUR/USD exchange rate rises by 2.1 pips to 1.06835. You Cashout your trade and have a new balance of $100,019.66. You just made $19.66 only because of a tiny fluctuation in the exchange rate!
The pipette functions much like a pip, and represents 1/1000th of a cent. If we were to use the above example one more time, each change in pipette is worth 1 USD.
In other words, those tiny numbers can make a huge different in profit.
The Japenese exception
Everything you just learned is valid for all best Forex trading Australian Guides, with the exception of the Japanese Yen. The Yen is actually quoted only to the 2nd and 3rd decimal places, where the 2nd decimal is the pip and the third is the pipette.
For example if the USD/JPY exchange rate is 123.398, the 9 is the equivalent of a pip and the 8 is the equivalent of a pipette.
Your head is probably spinning from this lesson, so we will try to give you a quick summary of what we just covered:
- The exchange rate is the value of purchasing one cfd trading using another.
- The currency that you are purchasing is the base currency, or the first currency listed in a currency pair.
- The exchange rate represents the amount of the quote currency (second currency mentioned in the currency pair) needed to purchase 1 unit of the base currency.
- Traders quote currencies down to fractions of a cent, known as pips and pipettes.
- The pip is the fourth decimal place in the exchange rate (for almost all currencies), and the second decimal place for the JPY.
- The pipette is the 5th decimal place in the exchange rate (for almost all currencies), and the third decimal place for the JPY.
- Even a small fluctuation of a pip or pipette can greatly influence the profitability of a trade.
Got it? Good.
But now you are probably thinking to yourself: “This is all very interesting, but I am not a millionaire, and I do not have 100,000 USD to invest in currency trading. So why on earth do I care?”
Great question. The answer is that you can easily have $10,000 or $100,000 to trade, even if you don’t have that kind of money in your bank account. This is due to the concept that we will be covering in a later lesson: Booster or Leverage Multipliers.
But before we get to leverage, we first need to examine what it actually means to make a trade.