Mistake: Ignoring Spreads When Choosing Setups

[Fairman]

Mistake: Ignoring Spreads When Choosing Setups

A setup can look attractive on the chart and unattractive in the numbers once costs are included. Many traders never check.

Suppose your stop is 8 pips and your target 16 pips, a nominal ratio of one to two. With a spread of 2 pips, the effective risk is 10 pips and the effective reward 14 pips, if the stop triggers on the bid or ask side as relevant. The ratio falls to about 1 to 1.4. To break even, you need a win rate of about 42 percent, not 33 percent.

On smaller timeframes and tight stops, the spread is a big share of the risk. At wider stops, it matters less. A setup with a 40-pip stop and a 2-pip spread has a 5 percent cost, which is minor.

Compare spread against the stop distance before every trade. A common guideline is to avoid trades where the spread exceeds a set share, such as 10 to 15 percent, of the stop.

Also consider timing. Spreads widen at rollover, around news, and during thin hours. A setup that triggers at a bad time costs more.

Choose pairs and sessions with lower spreads for tight-stop strategies. And factor the cost into expectancy calculations.

If the spread consumes too much, widen the stop and reduce the size, or skip the trade.

Practical step: add a spread-to-stop ratio to your journal, and look for the threshold above which results deteriorate.

[Fairman]

The spread-to-stop ratio column is a great addition. After a few dozen trades you'll probably find a point where results drop off, and that becomes a simple filter. Calculate it as the spread at entry divided by the stop distance. One pip of spread against a 10 pip stop works out to 10 percent. A 2 pip spread on an 8 pip stop is 25 percent. Record the actual spread when you enter, not the typical one advertised by the broker, because it changes a lot by session. Many people find their results get much worse above 15 or 20 percent, which tells you which setups to skip or where the stop needs more room.

[Fairman]

This is the main reason I'm careful with tight scalps around rollover and news. The setup on the chart is identical, but the maths of the trade is completely different. Around 10pm Lagos in summer, when the New York day rolls over, spreads on many pairs can go from under a pip to three or four pips for a short while. On crosses like GBPNZD it can be worse. A scalp with an 8 pip stop in that window could lose half its risk to spread alone, and stops can trigger on the widened ask or bid without the chart showing it. Waiting 20 or 30 minutes for spreads to settle costs nothing.