Here's How to Size Up the Spread in Currency Pairs

Joined : 23 Dec 2007 Posts : 235 Location : Nigeria

Here's How to Size Up the Spread in Currency Pairs

Today's commentary is by Sean Hyman, our Currency Director and editor of The Money Trader.

Good Day Currency Traders!

When you're trading currencies on the trillion dollar FX market, you have to choose a few items when placing your trade. You must choose:

1. The currency pair (currencies are traded in pairs because you only know what they are worth when you relate/compare them to another currency.)
2. To buy that currency pair or sell short
3. Your stop-loss
4. The spread - difference between its buy and its sell quotes

That brings me to today's topic: Spreads.

Why Go Wide?

At first it may not make sense to choose a currency pair with a wide spread. After all, why trade a currency pair with an 8 pip spread when you can trade a pair with a spread that's only 2 or 3 pips? With a wider spread, your pair has to move more so you can profit.

However, let's take a step back and compare apples to apples. Usually traders choose small spreads, because they're afraid it will take too long to overcome the trading spread to profit on the trade. They figure a 2-3 pip spread on EUR/USD is much more favorable than EUR/AUD's 8 pip spread.

(Note: these spreads could be a bit smaller or larger from broker to broker).

According to the Average True Range (ATR) indicator below, we see that EUR/USD trades around 100 pips a day on average. It will have a 2-3 pip spread depending on which broker you trade it through.

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Different Strategies - Same Results

On the other hand, using the same indicator it shows that the EUR/AUD trades around 216 pips a day with a 6-9 pip spread (depending on who you trade through).

Wider Spread = More Volatility
The chart shows that the EUR/AUD can just as easily move 6-9 pips because it trades well over 200 pips a day on average. So it won't take you long to profit as long as you're betting the pair will head in the right direction, because the pair is volatile so it will move quickly.

If you were trading the less volatile EUR/USD, then you would have had to wait for the exact same thing to profit from its 2-3 pip spread.

So the spread may be double but so is the volatility. That means a wider spread can move just as fast as a shorter spread.

So keep this in mind when trading. Look for the best trading set ups and don't confine yourself to 3-4 pairs just because they have a 2-4 pip spread. Spreads matter, but volatility can move a trade fast enough to overcome the spread.

Sean Hyman, Currency Director