It’s All About the Spreads
This narrows down our list of potential currency pairs to the more active ones, although activity isn’t the most important consideration here, at least activity itself. Less active currency pairs will have worse spreads, and more active ones will have better spreads, and these spreads are reflective of the activity of the currency pair more than anything.
Spreads aren’t the only thing when it comes to selecting currency pairs to trade but it is the most important thing to be sure. Most forex traders undervalue the importance of spreads and when they end up struggling to make a profit they may not realize that it is this choice that is at least partly behind this.
A lack of proper trading skill is the number one reason forex traders struggle, but when we trade pairs that don’t have that great of a spread, we’re putting ourselves at a disadvantage right from the start. The bigger the spread, the more skill you need to make money from the pair, and the longer you need to hold your trades to allow yourself to be profitable. When you are low on skill and trade higher spreads, this is not a prescription for success.
The skill part needs to be first and foremost in our minds as far as what we need to have in place to succeed at forex trading or any form of trading, but we can make this task easier or harder than it needs to be by not paying attention to spreads enough.
The more active you are as a forex trader, the more important good spreads are to your success. This isn’t really a matter of looking back and seeing how much you paid in spreads in total, it’s a matter of what percentage the spread will play in a per trade basis.
More active traders place trades of a shorter duration than less active ones, and therefore seek to capture smaller moves with tighter risk management. The smaller the average gain per trade, the greater the impact of a spread.
If for instance you average 5 pips per trade net of the spread and the spread is 3 pips, you pocket 2 pips per trade net. If you can get the same 5 pips per trade and only pay only 1 pip for the spread, you’ve just doubled your average profit per trade.
Over the course of a year, you will have made twice as much money with this friendlier spread, 1 pip, than the much less friendly 3 pip spread with this scenario. If you are only averaging 3 pips per trade net of the spread, this will take us from making 2 pips per trade net to making nothing. If you are only making 2 pips per trade you will go from 1 pip per trade profit to 1 pip per trade loss.
One or two pips per trade may not seem like much, especially if you don’t place that many trades, but this does add up. This is why seeking a broker with more friendly spreads is so important, and provided that you are selecting from among reputable brokers, this will very often be the deciding factor in choosing one.
Forex brokers that offer the friendliest spreads also tend to be on the more reliable side as well, so this one selection can cover both vital elements in selecting a forex broker, although this does not excuse us from doing our diligence in examining a broker’s stability and trustworthiness.
With a good forex broker in place, we are still left from looking at the various spreads they offer with their currency pairs, which does differ and differs quite a bit. We need to confine our choices to those pairs which offer friendly spreads and avoid trading the ones that don’t, generally speaking anyway.
Performance Related Considerations with Currency Pairs
Better spreads aren’t the only thing to be looking at here, as we also need to consider things like how much a pair moves, how easy it is to trade, and how well we can trade it. These are all separate things to consider although they are all ones that need to be looked at when we are trading any security.
With forex trading though, we will be offered spreads that are at least pretty close if not identical to one another. We will be able to rule out certain pairs as good choices simply based upon their having too large of a spread, where the ones that do have at least acceptable spreads will then need to be looked at based upon their overall characteristics.
This is all about seeking profitable pairs to trade, and the most profitable ones in fact. Spreads affect the profitability of a pair, as does things like predictability and volatility. We need to be seeking enough of all of these things, as a pair that moves too slowly may be predictable but not volatile enough, or it might be volatile enough but not predictable enough.
There are two ways that we can determine how desirable the performance of a given currency pair is, and that is to look back upon prior results and see how well we could have traded it, and to actually trade it and see how well we do with it.
We want to make sure that we are not using a real money account to do this testing, and most forex brokers do provide you access to a demo account on the same software and under the same conditions as trading with real money. Proving trading ideas with a demo account is a great idea, although if we want to do that with real money, we can, but we need to be trading with very small trade sizes where any losses incurred will be very minimal if not virtually meaningless.
When we’re looking back on charts, what we’re looking for is to see how our trading ideas would have fared with a particular pair, and compare this with how we would have done trading another pair on the same day or at the same times. This will give us some real insight as to which is more suitable, although this is something that will not be settled just on one day or even a few days as we will need to allow each to show suitability over a longer time frame than this to be sure enough to go with one or the other in full force.
With trading them on a demo, we want to engage ourselves in both in real time and view the results from this perspective. Sometimes, a pair can look great on a chart but may have some characteristics that make it more difficult to trade in real time, too much choppiness for instance.
This real time vetting will also take into account any differences in spreads between competing currency pairs, as we will be comparing results based upon profit and loss here and that’s where the rubber meets the road when deciding between currency pairs.
Once we’ve decided all this, we will have narrowed the field to just a few or perhaps even a single currency pair to trade. Many traders just trade one, although you don’t just want to go with the most actively traded one, EURUSD, just because it’s so popular and just because this might offer the best spread.
Some brokers may offer a few pairs with the same friendly spread and the rest may have spreads that are two or three times higher as far as the other major pairs go, with minor pairs having considerably bigger spreads than this.
A difference of a couple of pips is going to matter a lot and this by itself can take a pair from being tradable to being inferior at least compared to pairs with better spreads, but if the difference is slighter or the spread offered is the same, at this point we can look to how tradeable one pair is over another to refine our choices.
Selecting the right pairs to trade is an extremely important component of forex trading success, and by itself can turn a good trader into a better one or a struggling one into one that is at least better set up to overcome whatever gap in skill exists and turn things around in one’s favor.
Editor, MarketReview.com
Monica uses a balanced approach to investment analysis, ensuring that we looking at the right things and not confined to a single and limiting theory which can lead us astray.
Contact Monica: monica@marketreview.com
Topics of interest: News & updates from the Office of the Comptroller of the Currency, Forex, Bullion, Taxation & more.
