Learn Strategies for Trading Spreads in Forex
Understanding the ins and outs of any endeavor is crucial, and trading the Forex market is no different.
It is very important to learn how it functions and operates, what are the distinctive characteristics, and how to take advantage of them to attain consistent profits.
There is one especially important concept that will help you learn how to trade Forex.
Anyone who has ever exchanged a currency knows that there are two prices, the price they buy the currency at, called the “Ask,” and the price they sell the currency at, called the “Bid”.
The Ask is always higher than the Bid and the difference between them is called the “Spread.”
Let’s explore the “Spread” a little more: understanding this concept should help you to learn how to trade Forex more efficiently.
The decentralized nature of the Forex market means that different brokers will have slightly different spreads on the same currency pair, and the spread is always variable.
Some brokers offer fixed spreads, but they do so by artificially marking up the prices they receive from their data feed providers (i.e. banks and financial institutions).
For most of the currency pairs the spread is larger than one pip, and for a few exotic pairs it can be as large as 10 or 15 pips.
It is the job of every Forex trader to be aware of the spread on the currency pair they wish to trade.
So how does this information help the beginning Forex trader?
Anyone who’s familiar with the OTA Core Strategy understands Supply and Demand levels, so let’s picture the scenario where a new Forex trader identifies a Supply level on the 2 mins chart of the GBP/AUD currency pair.
The level is between 1.5330 ~ 1.5335 (i.e. 5 pips wide), the trader, oblivious to the spread of the GBP/AUD places a limit order to short at 1.5330 with a protective stop just above the level at 1.5337.
Price rallies to the supply level, and when the Bid becomes 1.5330 the short position is initiated, price continues a bit higher to 1.5334 before reversing lower as expected. All good, right?
Not really. Unfortunately for this trader, he or she would’ve been stopped out for a loss before seeing price reverse lower at their level.
Why is that? Remember we said the Ask is the price we buy at, and it is always higher than the Bid.
The protective stop order at 1.5337 is an order to buy if the Ask hits this price.
The GBP/AUD pair has a wide spread of an average of 5 pips, what this means is that when the Bid rallied to 1.5330 and the short position was initiated, the Ask at that time was at 1.5335, and when the Bid continued higher to 1.5334 before reversing lower the Ask had reached 1.5339 thus triggering the protective stop order and closing the position for a loss.
A counter argument could be: "Then why not put the stop loss at a higher price?"
The simple answer is that this would significantly reduce the Risk-to-Reward ratio, because the target would remain the same (i.e. just before the opposing demand level) but the risk has just increased.
So what does this mean to a beginning trader trying to learn how to trade Forex?
It simply means that when it comes to trading the Forex market, it is best not to go to a time frame lower than 15 minutes. And if the currency pair has a very wide spread (i.e. larger than 5 pips), then it’s best to only swing trade it using the hourly time frame or higher.
"Ignorance of the law is no excuse" is a common saying in courts of law, and the same applies when it comes to trading the financial markets. Not knowing the rules of the game is no excuse for a losing trade.