The Science Behind the Spread

8 min read

Dear traders,

By quantifying the exact edge of brokers over traders due to the existence of a spread, traders gain a new degree of clarity on the “house edge”, which significantly contributes to the strategic engineering of systems and strategies with cookie-cutter precision, profitability, and finesse. 

This article delves deep into quantifying the hard science behind the transactional spread that novice, retail, and even institutional traders face on a daily basis when trading the FX market. 

Traders stand to gain most from the technical precision in risk and position management that will be covered in this article in a quantitative manner.

Breaking Down the Basics

Amongst the many trading strategies that are readily available on the internet, how many of them ACTUALLY work? Are the so-called “trading coach” sites selling you valid and applicable education, or are they just full of trash and out for your money? This primer delves deep into the most basic and fundamental aspect of trading – the spread, and attempts to answer the very question that puzzles both the novice and professional traders alike – what do I believe? 

By breaking down the metrics of simple trade executions and popular online trading models into a simple easy-to-understand linear interpretation, this article attempts to debunk why 90% of whatever contents traders find online are in fact, trash. By delving into the science behind spread, this article effectively quantifies exactly the edge of over-the-counter online forex brokers over retail traders and features a new, revolutionary perception that traders can adopt in order for them to formulate or augment their strategy to match today’s trading environment. Practical matrices are also provided to help newer traders gain a grasp over the house edge, as well as recommendations of ECS tools that have proven useful in the aspect determining  stop loss placement and profit taking levels.

“The ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed the world is ruled by little else. Practical men, who believe themselves to be quite exempt from any intellectual influence, are usually the slaves of some defunct economist.” – John Maynard Keynes, The General Theory of Employment, Interest and Money (1936)

More often than not, it’s ideas, not vested interests, which are dangerous for good or evil. My point is – be wary when someone tries to sell you an IDEA. The realm of FX is cutthroat one, full of people selling snake oil and false claims. 

A common idea is that if you plan to take 20 pips with a 10 pip stop, you only have to win 50% of the time to make 150%. 2 sets of that and you’ve effectively doubled your money, making 225%. Even if you are right only 40% of the time, you STILL make 120%. How hard can that be? After all, the trend is our friend. Who is to say that if we executed 10 trades in 10 different pairs, all going along with the trend, that we are going to be 60% wrong? We ought to have a lot more than a 60% probability of being correct since the trend is already established to be in our favour! Right? I Pity The Fool!

Only when we delve deep into the hard science behind the mechanics of over-the-counter (OTC) trading can we truly know first our shortcomings, and from there, be well-equipped with knowledge to devise a strategy that gives us a good enough edge. 

“If you know the enemy and know yourself, you need not fear the result of a hundred battles. If you know yourself but not the enemy, for every victory gained you will also suffer a defeat. If you know neither the enemy nor yourself, you will succumb in every battle. ― Sun Tzu, The Art of War

The Ugly Truth of Short-Term Trading

Cunningly elusive, here’s the ugly truth on short-term trading. If you enter a trade with a 10 pip target and a 10 pip stop, you’ll need a price to move 12 pips in your way while only allocating yourself an 8 pip margin-of-error. Ergo, just the basic fundamental mechanics of FX as an OTC spread based market puts the odds at 60% – 40% against you, and that’s under the best case scenario. That’s a huge edge traders are giving up to brokers, and the prime reason why most short-term trading approaches fail. To even be marginally profitable, the 10 pip TP 10 pip SL strategy has to be accurate to the 80th percentile – a degree of precision near impossible to sustain in the long haul. 

Now, let’s look at this in another perspective. Let’s consider and factor in the spread as our cost of doing business. Say if we are trading with a 10 pip SL and 10 pip TP, a 1.5 pip spread (market average) would cost us 15% of our capital. However, if we are trading with a 100 pip stop loss, this 1.5 pip spread would only cost us 1.5% of our capital input. Enter the cross quotes and the disparity becomes even more striking. On a 4 pip (market average) pair like NZD/USD or 8 pip (market average) spread pair like GBP/JPY the numbers are 40% and 80% versus 4% or 8%. Think about it. If you’re manning a business that has an 80% per transaction cost versus a business having an 8% per transaction cost, which is more likely to succeed?

Most Forex traders lose money and most of them love to trade short-term. While correlation doesn’t always imply causation, it inevitably does in the above case. Short term trading means engaging in short term risk. That, by definition, effectively stacks the odds against you.

Theoretically, in a perfect world, traders would trade with a 100 pip target and a 100 pip stop loss, greatly reducing their costs per transaction, greatly improving their probability of success, thereby leading to a very distinctive, consistent, positive equity curve. However, I’m pretty confident that most of us do not have the patience to hold trades that long in the real world. With this presumption, the question then becomes “What is a reasonable stop and target parameter that we should use on shorter term trades?”

A Balanced Stop Loss Size

While opinions may widely differ, if I had to put a number on it, I personally believe in a stop no less than 20-25 pips at least, plus the spread, depending on the nature of the pair. Any smaller and we’ll be risking getting chopped out by noise. Target setting would be, of course, highly dependent on personal strategy. Goes without saying that it should be at least 25 pips.

It is noteworthy to mention that I in fact do not use the above as a blanket rule. As many of you know, in CAMMACD trading, we use our proprietary ecs.ATR pivots and ecs.CAMARILLA to determine precise stop loss. In SWAT strategy, we use a combination of SWAT tools, master candles and fractals to determine stop loss. In ECS at least, we make it a point to include rules-based stop loss level determination to be a part of our strategy to ensure a high standard of consistency and a higher degree of precision. Having said that, you’d be surprised to see that our stop loss levels are often no less than 25 pips plus the spread, in line with our trading rules to give price breathing space – so that we do not get chopped up by noise.

Stops are critical in controlling risk but can also be detrimental to your equity curve. Getting chopped out for 7 or 8 trades in a row for a “small” 10 pip loss each time is effectively equivalent to taking a huge 70 pip hit, or even more, taking into account the spread. While that’s not too hard to make up if you’re trading with 100 pip targets, it is considerably more challenging if you’re executing trades with 10 pip targets. 

Here’s the crux. If we are going to trade short term either ways, we ought to at least leave ourselves some chance of success by not making stops ridiculously tight.

Good trading,
Davin Wu
Trader & Analyst

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