Spreads play a significant factor in profitable forex trading. When we
compare to the average spread to the average daily movement many
interesting issues arise. Namely, some pairs are more advantageous to
trade than others. Secondly, retail spreads are much harder to overcome
in short-term trading than some may anticipate. Third, a "larger" spread
does not necessarily mean the pair is not as good for day trading when
compared to some lower spread alternatives. Same goes for a "smaller"
spread - it does not mean it is better to trade than a larger spread
alternative.
Establishing a Base Line
To understand
what we are dealing with, and which pairs are more suited to day
trading, a base line is needed. For this the spread is converted to a
percentage of the daily range. This allows us to compare spreads versus
what the maximum pip potential is for a day trade in that particular
pair. While the numbers below reflect the values in existence at a
particular period of time, the test can be applied at any time to see
which currency pair is offering the best value in terms of its spread to
daily pip potential. The test can also be used to cover longer or
shorter periods of time. These are the daily values and approximate
spreads (will vary from broker to broker) as of April 7, 2010. As daily
average movements change so will the percentage that the spread
represents of the daily movement. A change in the spread will also
affect the percentage. Please note that in the percentage calculation
the spread has been deducted from the daily average range. This is to
reflect that retail customers cannot buy at the lowest bid price of the
day shown on their charts.
# EUR/USD
Daily Average Range (12):105
Spread: 3
Spread as a percentage of maximum pip potential: 3/102= 2.94%
# USD/JPY
Daily Average Range (12):80
Spread: 3
Spread as a percentage of maximum pip potential: 3/77= 3.90%
# GBP/USD
Daily Average Range (12):128
Spread: 4
Spread as a percentage of maximum pip potential: 4/124= 3.23%
# EUR/JPY
Daily Average Range (12):121
Spread: 4
Spread as a percentage of maximum pip potential: 4/117= 3.42%
# USD/CAD
Daily Average Range (12):66
Spread: 4
Spread as a percentage of maximum pip potential: 4/62= 6.45%
# USD/CHF
Daily Average Range (12):98
Spread: 4
Spread as a percentage of maximum pip potential: 4/94= 4.26%
# GBP/JPY
Daily Average Range (12):151
Spread: 6
Spread as a percentage of maximum pip potential: 6/145= 4.14%
Which Pairs to Trade
When the spread is placed into percentage terms of the daily average
move, it can be seen that the spread can be quite significant and have a
large impact on day-trading strategies. This is often overlooked by
traders who feel they are trading for free since there is no commission.
If a trader is actively day trading and focusing on a certain pair,
making trades each day, it is most likely they will trade pairs that
have the lowest spread as a percentage of maximum pip potential. The
EUR/USD and GBP/USD exhibit the best ratio from the pairs analyzed
above. The EUR/JPY also ranks high among the pairs examined. It should
be noted that even though the GBP/USD and EUR/JPY have a four-pip spread
they out rank the USD/JPY which commonly has a three pip spread.
In the case of the USD/CAD, which also has a four-pip spread, it was
one of the worst pairs to day trade with the spread accounting for a
significant portion of the daily average range. Pairs such as these are
better suited to longer term moves, where the spread becomes less
significant the further the pair moves.
Adding Some Realism
The above calculations assumed that the daily range is capturable,
and this is highly unlikely. Based simply on chance and based on the
average daily range of the EUR/USD, there is far less than a 1% chance
of picking the high and low. Despite what people may think of their
trading abilities, even a seasoned day trader won't fair much better in
being able to capture an entire day's range - and they don't have to.
Therefore, some realism needs to be added to our calculation,
accounting for the fact that picking the exact high and low is extremely
unlikely. Assuming that a trader is unlikely to exit/enter in the top
10% of the average daily range, and is unlikely to exit /enter in the
bottom 10% of the average daily range, this means that trader has 80% of
the available range available to them. Entering and exiting within this
area is more realistic than being able to enter right in the area of a
daily high or low.
Using 80% of the average daily range in
the calculation provides the following values for the currency pairs.
These numbers paint a portrait that the spread is very significant.
* EUR/USD
Spread as a percentage of possible (80%) pip potential: 3/81.6= 3.68%
* USD/JPY
Spread as a percentage of maximum pip potential: 3/61.6= 4.87%
* GBP/USD
Spread as a percentage of possible (80%) pip potential: 4/99.2= 4.03%
* EUR/JPY
Spread as a percentage of possible (80%) pip potential: 4/93.6= 4.27%
* USD/CAD
Spread as a percentage of possible (80%) pip potential: 4/49.6= 8.06%
* USD/CHF
Spread as a percentage of possible (80%) pip potential: 4/75.2= 5.32%
* GBP/JPY
Spread as a percentage of possible (80%) pip potential: 6/116= 5.17%
With the exception of the EUR/USD, which is just under, 4%+ of the
daily range is eaten up by the spread. In some pairs the spread is a
significant portion of the daily range when factoring for the likely
possibly that the trader will not be able to accurately pick
entries/exits within 10% of the high and low which establish the daily
range. (To learn more, see Forex Currencies: The EUR/USD.)
Final Thoughts
Traders need to be aware that the spread represents a significant
portion of the daily average range in many pairs. When factoring likely
entry and exit prices the spread becomes even more significant. Traders,
especially those trading on short time frames, can monitor daily
average movements to verify if trading during low volatility times
presents enough profit potential to realistically make active trading
(with a spread) worthwhile. Based on the data the EUR/USD and the
GBP/USD have the lowest spread-to-movement ratio, although traders must
update the figures at regular intervals to see which pairs are worth
trading relative to their spread and which ones are not. Statistics will
change over time, and during times of great volatility the spread
becomes less significant. It is important to track figures and
understand when it is worth trading and when it isn't.
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