The topic of this week’s article is inspired by a recent interview I did last week with Online Trading Academy’s Master Instructor and Power Trading Radio host, Merlin Rothfeld. I have known Merlin for quite a few years now and he is probably one of the best traders I know. He is one of the original instructors of Online Trading Academy’s education and a truly dynamic host for Power Trading Radio.
Every month or so, I get the opportunity to appear as a guest on Power Trading Radio, covering the Tuesday Forex spot and when I did my show last week, Merlin and I were talking about the impact of the sudden interest rate hike in Turkey and it’s effect on the Global Markets. While there were some big moves after the announcement, some of which we see most prominently on the US Stock Market Indexes and the Australian Dollar currency pairs, we spoke of the actual USDTRY currency pair and if it was a viable FX pair to trade. While on the back of the interest rate decision there was some incredible price movement, we both agreed that the pair itself was really not the most practical instrument to trade, due to it’s lack of liquidity and more importantly, the spread. As you may or may not know, the spread is the difference between the Bid price and the Ask price. Markets are like auctions and there has to be a willing buyer for a willing seller and vice versa. However, for a transaction to actually take place, the seller must agree to the price that they are willing to sell at and a buyer must agree to the price they are willing to buy at. This therefore is what creates the spread.
When we are buyers, we have to pay the Ask price and when we are sellers, we are made to sell to the willing Bid price. This spread, or the difference between the 2 prices, is what the FX broker or dealer makes a profit on. This fee, the spread, replaces the fixed commission cost found when trading other asset classes such as Equities, Futures and Options. In FX, the wider the spread the more costly it is to take the trade itself, as the spread means you will be charged when you get into the trade and thus this cost needs to be factored into the reward risk potential of the trade. The more spread you pay, the more pips you need to make on the upside to cover this cost. At the time of writing this article, the Bid/Ask on the USDTRY was 2.2068/2.2105 or 37 pips. This is huge in terms of FX trading and makes trading a pair like this very expensive for the average trader, especially when you consider that at the same time, the Bid/Ask EURUSD was 1.3590/1.3592, just 2 pips….what makes more sense to trade economically?
Merlin and I were discussing this very dynamic on the show, which then led us to discuss the features and benefits of trading US Dollar Majors and Cross Pairs. The Majors are made up of the USD, GBP, AUD, CHF, JPY, CAD, EUR and NZD. A US Dollar Major is any pair, which includes the USD, such EURUSD or USDCAD. A Cross Pair is a combination of the majors except the US dollar, for example GBPJPY or EURAUD. Most regular currency traders are attracted to the major pairs, because they offer the tighter spreads and the most liquidity in the market. The typical characteristics of a cross pair however, see higher levels of volatility and slightly wider spreads. These spreads and higher volatility levels tend to make FX traders steer clear of a cross pair.
When I was speaking to Merlin on his show, he was telling me about how he enjoyed very small spreads because it allowed him to take very tight stops, the benefit being that it increased his risk to reward ratio on his trades. While I totally agree with this methodology, I also recognise that Merlin is a very accomplished trader and is good enough to understand what a good quality trading setup looks like on the smaller timeframes. No one can expect this level of proficiency when they first start trading. Another thing to remember is that when you start trading currencies you really need to make the very most of the big moves that happen. When a currency pair is stuck in a tight range it can be very challenging to make a decent risk to reward ratio and new traders can find themselves getting chopped to pieces if they don’t have the patience or the ability to find a good trade.
I encourage my students to open their minds to the possibilities of trading both US dollar majors and cross pairs because there are opportunities if you know where to look. Let’s take a look at the selection of spreads and ranges of a variety of pairs:
As you will see from the above screenshot the spread or the difference between the Bid and the Ask, tends to get wider as the volatility increases on a currency pair. Volatility can be seen in the Average True Range column, which I have sorted from smallest at the top, to largest at the bottom. Average True Range also known as ATR, is a powerful analysis tool which gives us a good idea of volatility and what we can expect from trade. The ATR, which I have measured in the above example, is based on a daily chart. We can see that EURGBP typically only moves around 63 pips in a day while the GBPJPY, is capable of well over 200 pips. If you are attempting to enjoy the benefits of true set and forget swing trading in the Forex markets, it becomes very difficult to make a decent reward if you’re trading something with a smaller daily range.
Now as you will notice, those currency pairs which you do have the large ATR values also have a larger spread. I have seen spreads sometimes on these cross pairs as high as 12 pips, however this is usually around the Sunday opening, which is always light volume. In typical market conditions, around six pips can be more realistic. A larger spread like this can often be daunting for an inexperienced trader and put them off of even considering taking a trade. However, I would suggest these unique opportunities should warrant your consideration, as big movies like these can be incredibly profitable if you’re on the right side of the trade and use relatively small stops to get you out if you are wrong. Of course it will cost you more money on a spread to take the trade in the first place, but wouldn’t you spend a little bit more money getting in if you knew you could make a lot more getting out?
Try not to fall into the trap of just focusing on the popular US Majors with the tightest spreads, as these are not the only opportunities out there for the disciplined FX trader. In fact, I like to trade as few trades as I can and make the very most of the ones I get into and which work in my favor. It makes little sense to me to be jumping in and out of trades just because they have a tight spread. If they are not really moving or following through as much, then they really are not going to be very profitable in the long run. You can try to dodge a larger spread all you like but if you up the frequency of your entries then you will only end up increasing your costs by paying a smaller spread across more trades, when you could have just paid a little more spread on the entry for a pair which moves more and left the trade alone to develop into a larger winner if it works in your direction. The world of FX has many setups and quality trades out there but only if you take the time to look for them. I hope this was helpful to you.
Until next time, be well and take care,