Spread reduction can be very exciting for traders. The promise of "free" cash with a good scalping strategy can make a trader's head spin and their fingers very 'trigger-happy' (by which I mean traders start taking many trades).
Let's use some examples.
First of all, let us compare EUR/USD (1-pip spread) and a high spread pair like AUD/NZD (6-10 pip)*
Ask yourself if you could be trading successfully the EUR/USD with a 6-10 pip spread. The answer is obvious. Many trading systems will fail miserably, because systems are usually optimised to trade with low spread pairs. When it comes to scalping, it's an absolute must.
There are other important factors to consider:
- account type
- stop-loss vs stop grab
- spread percentage.
ATR is the indicator that measures the volatility. It also projects high and low range based on its calculation. The higher the ATR, the higher the volatility.
Hypothetically, in the above scenario, the AUD/NZD moves 60 pips a day, and you pay a 5-6-pip spread. While the Euro is moving 90-120 pips a day, AND you only pay a 1-pip spread. We believe it is a no-brainer which pairs you should be trading and which to avoid.
I personally prefer to trade pairs with high ATR.
Another factor to consider is if you are on an ECN account and can get hit on the bid/offer with your limit orders. In this case, you would get a slightly reduced spread cost, as you can get your entry and exit out of the market with limit orders filled at your prices.
Then again, depending on your strategy, using only limit orders can mean you miss out on some opportunities. Good thing is that you can have ECN-like spreads with an Admiral.Markets account.
Stop-loss vs. stop grab
You also need to consider what happens when your stop gets hit on those high spread pairs. You are paying a huge spread when your 'market order' stop-loss order hits the market. That might create a pattern that collects all stops above or below it. The more stops are hit, the stronger the move of the price is going to be.
This might even push the price to next support or resistance level, creating a fake out cause by a stop grabber.
There's one further consideration that should be mentioned— correlation. In financial terms, correlation is the numerical measure of the relationship between two variables. The range of correlation coefficient is between -1 and +1.
A correlation of +1 denotes that the two currency pairs will flow in the same direction. A correlation of -1 indicates that the two currency pairs will move in the opposite directions 100% of the time. Meanwhile, a correlation of zero denotes that the relationship between the currency pairs is completely arbitrary.
So in the chart above, you can see that EUR/GBP and GBP/USD are negatively correlated (-98). This means that they move in a completely opposite direction. If you compare the current ATR of EUR/GBP(70) to ATR of GBP/USD(128), it is very easy to see which pair to trade. Moreover, the spread on EUR/GBP is 2.5 pips, while GBP/USD has the spread of 1.4 pips.*
Very occasionally you'll see that our favourite brokers change the spread and allow you to trade with extremely low costs. Currently, it's possible to trade with a 20% discount on the following pairs:
- EUR/USD – Typical Spread 1.0 – which means a potential economy 2 USD per lot, 200 USD per 100 lots.
- GBP/USD – Typical Spread 1.4 – economy 3 USD per lot, 300 USD per 100 lots
- USD/JPY – Typical Spread 1.1 – economy 3 USD per lot, 300 USD per 100 lots
- USD/CAD – Typical Spread 1.00 – economy 3 USD per lot, 300 USD per 100 lots
- GOLD – Typical Spread 18 – economy 4 USD per lot, 400 USD per 100 lots
The trader's account should be in a better position to handle setups with larger drawdowns before problems with margin hit the radar. Traders are, therefore, less limited in terms of the number of trades. This can particularly be useful when the market accelerates in its price action, and it suddenly offers the trader more opportunities to trade.
The spread fluctuation might also depend on market factor namely, liquidity. A market that is liquid means it has many trades on a daily basis and is composed of many active traders. The Forex market is extremely liquid because hundreds of banks and millions of individuals trade currencies every day.
The spread is then divided by the average daily range of a currency pair. This gives us a percentage which tells more precisely how much the spread costs. The lower the number, the better it is.
The spread can be considered an opportunity cost in the sense that it might reduce the amount of profit gained from the daily range calculated by ATR. The higher this opportunity cost, the more likely it is to convert to losing trades and, subsequently, real financial losses.
These are some examples using current average spreads* and ATR (the lower, the better). Keep in mind that above mentioned spreads will be lower by 20%.
* MT4 average spreads as of January 26 2017
ATR (14): 87 pips
Typical Spread Value : 1.0 pips
Spread as a percentage of ATR: 1.0/87 = 1.14 %
Typical Spread Value: 1.4 pips
Spread as a percentage of ATR: 0.85 %
Typical Spread Value:1.1
Spread as a percentage of ATR: 0.72 %
Typical Spread Value:1.0
Spread as a percentage of ATR: 0.8 %
Typical Spread Value:18
Spread as a percentage of ATR: 1.23 %
If we compare these numbers to let's say:
Typical Spread Value:6.5
Spread as a percentage of ATR: 3.11 %
We can easily understand the effect of low spreads on opportunity costs. Additionally, this is one of my accounts that benefitted from very low spreads with Admiral Markets broker.
(Please note past performance may not be indicative of future results)
My suggestion is for anyone who is seriously thinking about scalping and intraday trading to consider the new benefits of standard Admiral Markets account as they would be best served with such low spreads.
Cheers and safe trading,