forex-scalping.com

Spread to volatility: a ratio that filters trades

Raw spread says little without context. A 1 pip spread on a day with a 150 pip range is cheap. The same spread on a 30 pip range is expensive.

The ratio of spread to recent volatility gives a better measure. A simple version divides the current spread by the average true range of the last ten one-minute bars. When the ratio is below some threshold, say 0.15, trading conditions are favorable. When it rises above 0.3, the cost is eating too much of the movement.

The filter adapts to conditions. In quiet markets, even a narrow spread can be too costly. In fast markets, a wider spread is acceptable.

It also helps explain why some strategies work only at certain times. A signal that shows up during the London open, with a high volatility and a low ratio, might not be profitable at 3am when the ratio is bad.

Implementing it takes a few lines of code or a small indicator. The threshold can be tuned against historical results, with the caution that a heavily optimized value tends to fail out of sample.

What spread-to-range ratio has served as a cutoff on the pairs traded here?

A scalp aiming for four pips on a pair with a 0.8 pip all-in cost pays a fifth of the target just to enter and exit. Aiming for ten pips on the same pair pays less than a tenth.

That ratio, cost divided by target, shapes whether an edge can exist at all. At 20 percent, the strategy needs a much higher win rate or a bigger reward than risk to stay positive. At 5 percent, there's breathing room.

It also explains why some scalpers quietly drift toward larger targets over time. The fine-tuned two-pip approach looked great until real costs were counted.

The ratio changes through the day. At the London open, the spread might be 0.4 on a major, and the same target looks cheap. Late in New York, it might be 1.2, and the same target looks expensive.

A useful practice is to compute the ratio live and skip trades when it crosses a threshold, say 15 percent. It works as a spread filter built from the strategy's own numbers instead of an arbitrary pip limit.

Brokers' own spread tables hide this ratio, since they report spreads in pips without reference to the target. A simple way to see its effect is to graph the strategy's net result against the cost-to-target ratio for each trade. The trades taken at low ratios, in tight-spread hours, tend to carry nearly all of the profit. The trades at high ratios often lose even when the direction is right.

Targets can also be adjusted by condition. When the spread is tight, a smaller target works. When it widens, the target needs to scale up in proportion, or the trade should be skipped. A formula that sets the minimum target to at least six or seven times the current spread keeps the ratio under control without any complicated logic.

It also changes the way pairs are chosen. A pair with a wide average range and a modest spread has a lower ratio for the same target than a pair with a narrow range and the same spread.

Which ratio of cost to target has proved to be the break-even line in actual results?