The importance of the spread in trading

Is the spread important in financial trading?

The answer is, without a doubt, yes, the spread is very important in trading. But it depends on the context.

If we do day trading, then the spread is very important, and if we have a medium term trading strategy, with trades that last days or weeks, then the spread is not that important.

The question is that the majority of people that start in this world, do so attracted by the quick profit and the most famous way for that is the so-called day trading. That is what most brokers in the world claim; as well as the majority of people who sell courses or signals. They sell the hope that you can win a salary every day doing day trading and go to riches. It ensures that millions of traders in the world end up going bust. Only a handful survive, and just a very few may win. However, the percentage of winners increases dramatically when the timeframe is bigger.

Example of spread cost in forex day trading

 

If we trade a forex pair with a spread of 2 pips, then it seems that the cost of the operation is just two pips, which is in part true. But the problem is that every time we buy or sell we pay the spread. So when we buy a pair, we pay two pips and when we sell the same pair we pay those two pips again.

For example, we have a pair quoting 1,4008/1,4010. If the price moves up two pips and we sell, we will win 0 pips. If the price goes down two pips, we will lose four pips. If the price moves up four pips and we sell, we win two pips, and the opposite we lose six pips. As you see, the shorter the move, the worse for us. And this is one of the reasons that we should avoid day trading.

It is a very big problem for scalpers who want to beat the market consistently. If a scalper wants a ten pips win, he will have to wait till the price moves 12 pips in his favor. If he sets a ten pip stop loss, it will be filled when the market moves eight pips against him. So as you can see, this is not a very good reward ratio for a trader. A trader who bets blindly will win 50% of the times and in a case like that he will have to have 1.5 wins per every loss to go even. It is because every time he is right and the market move ten pips he will win eight pips. And every time he is wrong the market moves ten pips, and he loses 12. So for an equal move he loses 1.5 more than he wins.

Not a very good situation.

We need to win 60 (12) times and lose only 40 (8) for a move of the same size (10 pips). A blind monkey betting has the same chance of success in the long term.

Trend trading advantage over day trading

This problem is not so big when it comes to swing or trend trading. When you have a 100 pips stop loss, it does not matter much if the spread is 2 or 3 pips. When the price moves 100 pips, and I am right I will make 98 pips. When the price moves 100, and I am wrong I will lose 102 pips; so the ratio here is not as bad as it is in day trading or scalping.

Sure, we still have to win more times than we lose, but it is not impossible.

So, my advice is simply not to do day trading. And if you do, please look for a security with the lowest spread possible and set wide stop and profit levels.

A security with one pips spread that normally moves 10 pips per day is not suitable for day trading, and probably not for trend or swing trading either.

If you want to try day trading, I say that you had better prove your strategy with a broker that offers very small lots. So you can practice with real but small money and see if it works.

P.S. This is a personal translation from my spanish blog www.brokerparacompraracciones.com.

Thanks for reading and sharing.