Trading profitability depends on spreads

It is surprising how many traders, especially retail traders, do not understand the importance of spreads. Traders tend to focus on price when trading and often do not consider the spread.  Yet the spread—the difference between the bid and ask prices of a currency pair—really represents the cost of trading, and the higher the cost of trading, the more difficult it is to trade profitably.

On many platforms, the spread is hidden or obfuscated.  Some forex dealers do not show the spread explicitly. Others publish spreads, but they vary dynamically at such great frequency that it’s difficult to identify the actual spread at the exact moment you enter a trade.

To better understand the affect of spreads, we did an analysis of all trades executed by our trading clients in 2010. If the spread had been zero on all their trades (where we assume the opening price is the midpoint between the bid and the ask, and the closing price is the midpoint as well), then all our customers combined would have realized profits in the tens of millions.

This substantiates the observation made in my previous post that our customers mostly get it right directionally. They are good. But because there is a cost of trading, paid through the spread, and our clients (in aggregate) incurred losses overall in 2010. What turned the potential profits into an overall loss? The spread and the spread alone–even though OANDA has very competitive spreads that are often lower than the spreads of other dealers. Had our spread been tighter, our clients would have been profitable in aggregate.

The relationship between spreads and profitability

Consider a trader making two round-tip trades a day on average using a leverage of 10:1.

If the trader executes these trades at a dealer with a spread of 2 pips and another trader makes exactly the same trades at another dealer offering a spread of 1.5 pips, then the second trader will have a 25% higher annual return on their equity than the first trader. That is, if annual return on equity for the first trader is -5% (i.e., he incurs a loss), then the second trader using the dealer with the tighter spread would have an annual return of 20%.

The second trader would therefore have a highly profitable trading strategy, while the first trader would have an unprofitable trading strategy—despite both trading strategies being exactly the same. (Try out this scenario or experiment with a few others at spreadcalculator.com.)

Switching to a platform with lower spreads has obvious benefits. But making a meaningful comparison between forex dealers in today’s marketplace is enormously challenging:

• Dealers with wider spreads do everything they can to obfuscate that fact.

• Most dealers show different prices to different clients. Sometimes this is to support a cut for an IB. Other times it’s because they figure they can get away with it and generate more revenue from a client.

• Different currency pairs have different spreads; quotations on EUR/USD may look competitive, but what about other pairs?

• Spreads tend to increase with ticket size: the larger the ticket, the wider the spread. Thus, platforms based on matching engines, like ECNs, may advertise tight spreads but their depth-of-book may be illusory or fleeting, so that quoted spreads may not be available for larger tickets. Similarly, some dealers may show spreads that are (without mentioning it clearly) only applicable to smaller ticket sizes.

• Spreads on the interbank market tend to fluctuate—going higher when liquidity is tight or price volatility is high (for example, when numbers are reported). Some platforms offer better average prices for those who primarily trade on the numbers, while other platforms offer better average prices for those who don’t. (Some online dealers “guarantee” the same spread regardless of market conditions, but such guarantees typically come at the cost of higher overall spreads. Be sure to read the fine print of such guarantees!)
  

• Quality of execution is equally important to spreads. Re-quotes, slippage, and stop-hunting are all patterns that artificially increase the effective spread. Frequent slippage will sabotage the tightest spread. 

Caveat emptor and due diligence

Without hard comparative data, the best way to learn about dealers’ quality of execution and spreads is by talking with other traders. Ask them about their first-hand experiences using different trading platforms.

Keep in mind, however, that this can be a snake pit as well, since one trader’s dream may be another’s nightmare—especially considering that most forex dealers treat different clients differently. Also beware of what you read on the blogs—posts are often submitted by shills paid by a specific broker.

It would be helpful if an independent organization did a study comparing the spreads of different dealers, taking slippage and trade rejections into account. To accomplish this in a meaningful way, the organization must:

• Open real trading accounts with the different dealers.

• Trade identically on the platforms of the different dealers with real money using various trading strategies.

• Keep the trading element of the study confidential from the dealers, as some who typically offer different pricing for different clients may skew the study’s results by offering very good spreads during the research period.
  

Transparency is sorely lacking in forex. It’s long since time for dealers to disclose the fact that different clients get different pricing, and to disclose to clients what price “tier” they are in. It’s an issue we feel strongly about at OANDA, and something we continue to push for among regulators and our industry peers.