Home > How Much the Spread Affects Forex Day Traders

How Much the Spread Affects Forex Day Traders

Paying a spread is part of forex trading, yet many traders do not understand just how much of an impact it can have. To get an indication of how much a spread is potentially costing, it is helpful to look at the spread of a given currency pair relative to how much that pair moves in a day. Looking at it in this light, traders can determine which spreads are worth paying, and which are not. A lower spread does not necessarily make a pair better day trade candidate than a pair which has a higher spread but a larger intraday range.

Forex Account Type

For context, it is recommended that all day traders use an ECN forex account. ECN accounts provide traders with direct access to available liquidity (bids, offers and orders provided by other traders and institutions), with no broker intervention. This type of account provides smaller spreads than a traditional account.

What’s the difference? Traditional accounts often have a fixed spread, such as 2 pips, while ECN accounts have a variable spread based on what price is actually available in the market. With an ECN account the spread will fluctuate, but is usually always smaller than the spread offered on the traditional account (traditional accounts can also have variable spreads, but the spread is higher than the ECN account). ECN accounts also don’t have forex broker interference, whereas sometimes with a traditional account the broker won’t allow you to make a trade at the current price and will instead “re-quote” you a different price. This slight re-quote delay, and the differences between the price seen and the re-quote price, are not favorable for fast-paced day trading where every second and pip count.

The most significant advantage of ECN accounts is that you actually don’t have to pay the spread if you don’t want to. Assume a pair has a bid of 1.2550 and an offer of 1.2552. Potentially, you can put bids and offers at both these prices, respectively, and actually make the spread yourself. You can make 2 pips without the price even moving, assuming someone else fills your bid at 1.2550 and your offer at 1.2552. This is how brokers make most of their money, and with an ECN account retails traders can do it too.

Capturing the spread (trying to make profits of only a couple pips) isn’t a recommended day trading strategy, but the concept can be used to enhance returns on other strategies. Buying at the bid saves a small amount of money and selling at the offer saves a small amount. Do this whenever possible, instead of always buying at the offer or selling at the bid. The tiny amount saved on each trade adds up to a lot of money over many trades. Traditional accounts, which force you to pay the spread, don’t provide you with this flexibility.

ECN accounts are superior to traditional accounts in many ways, and for this forex brokers charge a commission. While traditional accounts have larger spreads, but no commissions, ECN accounts have a smaller spread but charge a small additional fee per trade.

Convert the Forex Spread

In order for the spread to mean something, compare it to the movement of the currency pair. Divide the fixed (or average) spread by the daily average range or daily price movement. This provides a percentage that describes the cost of the spread relative to volatility (or profit potential). The spread is an opportunity cost in that it reduces the amount of profit that can be captured from the daily range. The higher this percentage or opportunity cost the greater the chance of real financial loss to the trader. If the percentage is high, it will be very difficult to overcome the high cost of trading that pair and still produce a profit.

Track daily average range by recording the ‘daily high’ minus the ‘daily low’ in a spreadsheet, or use an indicator such as Average True Range (ATR).  You may also use the resources provided on the Forex Daily Stats page.

The spread is found by looking at the quote screen of a forex broker and is the difference between the bid and offer price. Compare brokers using myfxbook’s spread comparison tool (click “include commissions” if using an ECN broker to see the full cost of taking a trade).

Spread Versus Profit Potential

The spreads below are based on OANDA Corporation during the New York session in October, 2017. OANDA is a non-ECN U.S. broker that offers competitive spreads with no commissions.  I do not trade with OANDA. I use an ECN broker as recommended earlier.  OANDA was selected because the spreads are typical of what traders in the U.S are subject to as there are not many ECN brokers available to U.S. residents. Also, if you are paying higher spreads than those discussed below, you don’t need to be. For those using an ECN broker, your spread should be much lower than the spreads discussed below.

The spread is deducted for the ATR figure in the calculations to account for the trader not being able to buy at the low bid price (chart price) of the day.

Different brokers have different spreads. Insert your own spread (and commission, if applicable) to see how much it is costing you and to see which pair is the best for day trading given your situation.

Please note that spreads and volatility will change over time; stay on top of these figures to be sure the spread is not negatively affecting you too much.

Here’s how much the spread affects forex day traders….

EUR/USD

ATR (12): 78 pips

Spread: 1.2

Spread as a percentage of daily movement: 1.2/77 = 1.56%

When the average movement of the EURUSD is below 100 pips, it becomes harder to day trade. That doesn’t mean it can’t be day traded, but because movement is low trades need to be taken very selectively…and some days may not warrant trading at all. For more on this, see Find Day Trading the EURUSD Tougher Lately?.

GBP/USD

ATR (12): 106 pips

Spread: 1.5

Spread as a percentage of daily movement: 1.5/104.5 = 1.44%

USD/JPY

ATR (12): 74 pips

Spread: 1.1

Spread as a percentage of daily movement: 1.1/72.9 = 1.51%

GBP/JPY

ATR (12): 129 pips

Spread: 2.1

Spread as a percentage of daily movement: 2.1/126.9 = 1.65%

AUD/USD

ATR (12): 56 pips

Spread: 1

Spread as a percentage of daily movement: 1/55 = 1.82%

USD/CAD

ATR (12): 83 pips

Spread: 1.5

Spread as a percentage of daily movement: 1.5/81.5 = 1.84%

USD/CHF

ATR (12): 75 pips

Spread: 1.5

Spread as a percentage of daily movement: 1.5/73.5 = 2.05%

EUR/JPY

ATR (12): 85 pips

Spread: 1.7

Spread as a percentage of daily movement: 1.7/83.3 = 2.05% 

NZD/USD

ATR (12): 60 pips

Spread: 1.3

Spread as a percentage of daily movement: 1.3/58.7 = 2.21%

What Forex Pairs to Trade

It is not the exact percentage that matters, but rather we want to be day trading the pair with the lowest percentage.

Keep in mind the percentages are only for one transaction (a buy for example). If exiting in the same day, or entering/exiting multiple times per day this will compound the percentage of daily move which will be given up to paying the spread. This effect can be reduced by trading with an ECN account and buying at the bid or selling at the offer when possible (avoiding the spread).

By looking at the numbers, a few things become relevant:

  • Paying the spread can be very costly.
  • A low spread does not necessarily mean a “better deal.”
  • Some common day trading pairs are not ideal for day trading when volatility is low.

Based on these statistics (and yours may be different because your spread is different), at this time the GBPUSD is the better day trading choice. Even though the spread is slightly higher than the EURUSD, because of the higher volatility less profit potential is given up by that spread.

The NZDUSD, USDCHF and EURJPY as some of the worst choices for day trading. The volatility at the time of writing doesn’t warrant paying the spreads that OANDA is charging.

Over time, the EURUSD and GBPUSD have consistently ranked as the best day trading pairs, mainly due to their lower spreads and decent volatility. Sometimes the GBPUSD is a far superior day trading choice, and other times the EURUSD is. Pay attention to the spread and volatility to determine which one is the better choice at any given time.

These numbers are in constant fluctuation and change over time. What is a great day trading candidate today may not be next month. Monitor the numbers continually and only day trade pairs with the lowest percentages.

Higher volatility means the cost of the spread is diminished. Therefore, it is wise to avoid trading in very sedate environments where there is little profit potential.

One Step Further With Forex Spreads

The forex market is open 24 hours a day during the week, yet a day trader won’t be trading that entire 24-hour period. Gain a better insight into spreads, costs and profit potential by only considering the time of day you are actually trading. You only trade for 2 hours a day, it doesn’t matter what the volatility is for the entire day, it only matters what the volatility and spreads are like for your 2-hour window. Compare percentages (as described above) for the times you trade to find the best day trade candidate for that time of day. For more on this topic see Best Time of Day to Day Trade Forex.

As an example, Bill trades the EUR/USD between 9:00 AM and 1:00 PM EST each day. All positions are entered and exited during this time frame (no over-night positions). The daily (full 24 hour period) average range does not accurately reflect the profit potential Bill will see during the time he trades.

Bill keeps track of high and low prices in a spreadsheet between the 9 AM and 1 PM each day and discovers that the average price movement between these times, over the last 12 sessions, is 50 pips compared to the daily average which is 78 pips (statistic above). Therefore, Bill uses only the data that applies to him (50 pips) in making is his percentage calculations. This will help him isolate the best forex pairs to day trade for this time of day. Analyzing the actual time we trade (not just full-day data) can also provide fruitful information which aids in setting stop loss levels, profit targets and strategy development.

How Much the Spread Affects Forex Day Traders – Summary

Comparing the spread to the daily average movement produces a percentage which tells us how much of that daily range we are giving up because of the spread.  Day traders should avoid forex pairs which have a high percentage. High percentages are created by low volatility or by a high spread. Continually monitor average intraday movements to determine which pairs are best to day trade, as the statistics constantly change. A good day trade candidate today may not be good next week. Try to track the statistics on your own, in a spreadsheet, for the exact times you trade. Tracking stats for the exact time will give you a better idea of which pairs to trade at which times, and may also give you clues to improve your strategies. The GBPUSD and EURUSD are often the best day trading pairs, although one is usually better than the other.

Trading with an ECN broker greatly reduces the problem of the spread, and opening an ECN account is typically a step worth taking if you want to take your day trading to the next level. With ECN brokers, the spreads are typically smaller than in the example above. ECN accounts also allow traders to capture the spread, like brokers do, but in exchange a commission is paid.

By Cory Mitchell, CMT

Check out my  The Forex Strategies Guide for Day and Swing Traders 2.0. It leads you step-by-step through a process for becoming a successful trader, as well as providing strategies and trading plans you can use to build your capital in a risk-controlled manner. This eBook is a complete course on forex trading, from basics to advanced tactics.

 

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