Forex Spreads Trading Strategies & Tips
This article will explore top forex spread trading techniques and key tips traders should follow to protect themselves against a widening spread. The forex spread is the difference in price between the bid (buy) and the ask (sell) price. The spread can widen and narrow depending on a variety of reasons, which we get into shortly.
BEWARE A WIDENING SPREAD
One unique aspect of the Forex market is the manner in which prices are quoted. Because currencies are the base of the financial system, the only way to quote a currency is by using other currencies. This creates a relative valuation metric that may sound confusing at first, but can become more normalized the longer that one works with this two-sided convention. Forex trading in a pair does offer the trader a bit of additional flexibility, by allowing the trader or investor the ability to voice their trade against the currency that they feel most appropriate. Let’s take the Euro for example, and let’s say a trader has optimistic projections for the European economy and would thusly like to get long the currency. But – let’s say this investor is also bullish for the US economy, but is bearish for the UK economy. Well, in this example, the investor isn’t forced to buy the Euro against the US Dollar (which would be a long EUR/USD trade); and they can, instead, buy the Euro against the British Pound (going long EUR/GBP). This affords the investor or trader that extra bit of flexibility, allowing them to avoid ‘going short’ the US Dollar to buy the Euro and, instead, allowing them to buy the Euro while going short the British Pound..
1) KEEP AN EYE ON FACTORS WHICH AFFECT THE SIZE OF THE SPREAD
To avoid large spread costs associated with a widening spread, traders should be aware of the following factors:
- Volatility: Volatility in the market brought about by economic data releases or a breaking news event could trigger a spread to widen.
- Liquidity: A lack of liquidity in the market could also cause a spread to widen. Liquidity and volatility are two interconnected concepts. Illiquid currency pairs, such as emerging market currencies, are known for their high spreads. Illiquid markets can also be a cause of volatility.
- Spreads and the news: Before a popular news event, like the NFP employment number release, liquidity providers may widen their spreads to offset some of their risk caused by the event.
- Usually the spread will revert to its mean after a few minutes, so it is advisable for traders to be patient and only trade when the spread narrows.
2) CHOOSE HIGH LIQUIDITY FOREX PAIRS
Another forex spread trading strategy many traders –
particularly beginners – adopt is choosing high liquidity
forex pairs. Under normal circumstances, high liquidity
pairs have lower spreads. Your major currency pairs, the
EUR/USD (Euro Dollar), USD/JPY (Dollar Yen), GBP/USD (Pound
Dollar), USD/CHF (Dollar Swiss Franc), will have the lowest
spread amongst all currency pairs because they trade in high
volumes. These currencies do not always trade at low spreads
and because they are affected by volatility, liquidity and
the news which can lead to widening spreads.
Emerging market currencies like the USD/MXN (US dollar/Mexican Peso), USD/ZAR (US Dollar/South African Rand) or the USD/RUB (US Dollar/Russian Ruble), generally have higher spreads compared to your major currency pairs. Therefore, it is wise for traders to trade these pairs with less leverage, or no leverage at all. In the image below, the black boxes show the spread of the certain currencies. The major market currency pairs, the USD/JPY and EUR/USD display narrow spreads- 0.7 pips and 0.6 pips respectively. The emerging market currencies, the USD/ZAR and USD/RUB on the other hand, have extremely wide spreads 90 pips and 1000 pips respectively.
3) TIME OF DAY TRADING
The time of day influences forex spreads, so it can be useful factoring this in to your strategy. During your major market trading sessions - London, New York, Sydney and Tokyo - forex spreads are normally at their lowest due to the high volume being traded. Forex traders could trade during these times to take advantage of narrower spreads. When the London and New York sessions overlap, spreads can become even narrower. The hours shown below are Eastern Time. Between 8am and 11pm Eastern time the London and New York session overlap.
FOREX SPREAD TRADING EXAMPLE USING USD/JPY
If you combine all the above spread trading techniques, you can reduce the risk of trading at a high spread. It is important to remember these steps when executing a trade and when closing a trade because the spread may change from when you open the position to when you want to close it. Let’s look at a simple example using the USD/JPY, which is among the major currency pairs – meaning it has high liquidity and therefore very low spreads compared to other forex pairs. Keep an eye on factors that may affect the spread If we were to trade the USD/JPY, we need to make sure there are no shock-events or data releases that could affect the spread. You can do this by keeping up to date with the latest news and using an economic calendar. A sample from the economic calendar is below. Events with a ‘high impact’ have a higher chance of increasing the spread, so unless you are trading the news event, it is wise to trade around these events. Some events that could increase volatility, and the spread include: GDP releases CPI (inflation data) NFP (non-farm payrolls)
FURTHER RESOURCES TO SUPPORT YOUR FOREX TRADING KNOWLEDGE
If you’re new to forex trading, we recommend downloading our Forex for beginners trading guide to learn the basics. You can also register for free to view our live trading webinars which cover various topics related to the forex market, like central bank movements, currency news, and technical chart patterns.