Some time ago I wrote about the spread and the importance of that concept in the world of short term trading, especially day trading.
On that occasion I explained the problem of the spread and how that is going to affect very seriously the performance of our account in the long run (long run in the day trading world could be one or two months).
Normally, those who look forward to becoming day traders, start trading and do quite well at the beginning. A lot of them even start winning.
That is the moment of euphoria.
I have been through that moment; in fact everyone experiences that when things go well (always for a while)
This is valid for any trading asset as well as the timing, whether long term investing or short term trading. Only that in day trading the emotions acquire a special importance.
Obviously, it is not the same trading 5 times a month than 50 or 500.
In the majority of cases, those who want to be day traders end up seeing how their accounts decrease little by little since, normally things do not go as planned.
The marvellous tested system “J” seems not to work that well in reality.
¿What could be happening?
Bid ask spread trading cost
“Well, sure it is something temporary, normal conditions will come back soon”.
That is the way I thought in many instances, but “conditions” did not want to come back eventually.
After a few months, luckily (sometimes you just need a few days, like most who try the world of binary options), the trader will find out that his account is quite reduced.
In many cases, the account will have ceased to exist.
That is the truth about frequent day trading whether in futures, Forex, CFDs or even stocks, only that in stocks the ratio of “destruction” is lower.
Spread trading example
Let us go with an example, say the GBPUSD at 1.5510/1.5511.
I decide to buy at 1.5511.
If the price goes up 10 pips, the quote will be 1.5520/1.5521.
If I decide to sell I will get 9 pips of profit, which will be less if I have to count on a ECN broker commission.
On the other hand, if price goes down 10 pips, the quote will be 1.5500/1.5501.
If I sell, at the bid, I will lose 11 pips.
As we can see, when the price moves in the same magnitude in both directions we will lose twice the spread.
In other words, we pay the spread twice.
And this is fundamental in the world of short term trading.
If we win, we get 9 pips.
If we lose we lose 11 pips.
If we add a commission of 0.6 pips (round turn) we find that we would lose 11.6 pips and win 8.4.
Do you see the difference?
Well, the one who sell you the ask and buy you the bid, the market maker, see it perfectly. And with pleasure will offer you as many buys and sells as possible.
To be able to succeed in a case like that we should be able to win 12 times out of 20. Which means, only lose 8 times.
8.4 * 12 equals 100.8
11.6 * 8 equals 92.8
The moment you only win 11 times out of 20, you will be losing money.
Being right 12 out of 20 times for a move of the same size?
Would you that you win flipping coins 12 out of 20 times?
I bet you would not.
That is why true scalpers are the market makers, not the “traders”.
Spread trading Forex
I remember one case in particular in which after a long time doing disastrous day trading (eight months) I decided to have a look into my history performance.
In that case I had deposited 5.000 USD.
Eight months later the account was only 400 USD.
I closed and leave with the tail between the legs.
I had studied a strategy for the EURUSD and the GBPUSD and thought I could make 20% per month in average.
That strategy failed.
It was not even an extreme scalping system with dozens of trades every day.
On the contrary, it was a moderated day trading system with 4 or 5 trades a day at most.
The system only had to follow my “indicators”.
The fact is that of 4.500 USD lost, 1.000 were in commissions.
I traded more than 50.000.000 USD in notion.
Doing simple math I found out that I ended up paying 3.500 USD in spread, for a spread of 0.7 approximately.
In other words, the commissions plus the spread were close to the 4.500 USD lots in that account.
If I had traded without spread and commissions the result would have been nill.
The real problem with day trading is that you will find it very difficult to overcome this issue.
And you will not find the solution in courses or so called winning trading systems.
Day trading solution
The solution is simple: increasing your trading time range and going for bigger moves.
For instance, in the GBPUSD we will improve this problem by going for 100 pips instead of 10.
Or in the ES (SP500 futres) with a stop of 50 or 100 ticks, and a profit of 400, so to speak.
Without being perfect, at least we will be reducing the transaction costs.
A dramatic case when your spread costs become paramount is that of binary options. In those instruments we are paying a spread of 15% every time (85% payout).
If we win, we get 85 USD (if we bet 100); if we lose we are down 100 USD. That is the same as paying an entrance fee of 15 USD that goes straight to the broker spread.
Do you think you have a chance with that sort of spread?
I guess that for that type of payout the typical duration of a binary options account of 1.000 USD should not be much more than 133 bets ((1000/15)*2 for 100 USD bets).
Curious number that one, by the way (1000/15=66.6).