Home Beginner Market Structure Ditto’s Guide to Spread Cost Optimisation

Ditto’s Guide to Spread Cost Optimisation

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The Costs of the Trade

People get into the trading business to get a second income, imagining successful trades, high profits and growing equity. Usually, they forget the usual fact that to trade they incur in certain costs that amount a lot at the end of the month.
The broker is the intermediary that allows retail traders to access the market, and they make their living by commissions, spreads and swap costs.

Swap costs have been dealt with in this article. Therefore, we are going to analyse here spreads and commissions.

Account types:

Brokers usually offer the trader at least two kinds of accounts: One called Straight Through Process (STP) accounts and ECN Accounts.

STP Accounts

On STP accounts they include their commission as an added spread. Therefore the single cost for a trade is the spread. With these account types, it is expected a spread that goes from 1.1 pips on the EURUSD and GBPUSD pairs up to almost 23 pips on the USDSEK

 

Fig 1 – STP account spreads (click to magnify)

ECN Accounts

On the opposite spectrum, they offer ECN accounts to pros. ECN means electronic communications networks, which means the trader is in direct connection with the liquidity providers. Instead of wide spreads, the broker charges a commission proportional to the trade size. On this account types, spreads are tight in liquid pairs such as EURUSD, GBPUSD and USDJPY. But on others such as EURCAD, the spread is the same.

Fig 2 – ECN account spreads (click to magnify)

Liquidity and Volatility

We should remember that the added spread on STP accounts covers the broker’s commission, but this does not mean that spreads are the same every time. Spreads move up and down depending on the market conditions: The two factors affecting spreads are liquidity and volatility.

Liquidity is the term we use to refer to the number of active buyers and sellers in a particular moment. That number changes with the time of the day and the pair. For instance, The EURUSD, GBPUSD and EURGBP, which are the most liquid European pairs are less liquid during the early morning, while Europe is close. With the opening of the European bourses at about 8:00 UK time (9:00 CET) liquidity grows. Then, at 14:40 UK, 15:30 CET, comes the US Open and liquidity maximises. Then, we know that the spreads on the mentioned pairs will be tight after the European open and, also during the American session, that ends at 21:00 UK, 22;00 CET.

Not all pairs have the same interest for traders and investors. The most active pairs are the Majors: EURUSD, USDJPY, GBPUSD, AUDUSD, USDCHF, NZDUSD and USDCAD.

Exotics Such as the USDSEK, USDMXN, USDNOK and others show higher spreads, and lack of liquidity.

Volatility is an enemy of the tight spreads. When an economic event, such as a bad Non-farm Payroll number, shatters the market, volatility can create holes in one side of the trade. For instance, if the number is unexpectedly good for the Euro and bad for the Dollar, the EURUSD pair will have most of the liquidity on the buy side and not much on the sell side. If a trader is short the EURUSD, it will experience a large spread and a very bad final price to close his position.

Costs derived from Spreads and Commissions

Spreads and commissions are an added cost to every trade. Therefore it is proportional to the number of trades and the size of the position. That can be a lot of money at the end of the month.

Let’s consider the case of a trader with an STP account that does six daily 1-lot trades on the EURUSD. At the end of the month, the number of lots goes to 60.  The costs for just this pair goes to $660/month, which amounts to about $8,000 per year. If he does 2 to 3 pairs simultaneously, this amount could jump to 25K yearly. That is the amount a trader needs to rise in profits for just break-even. That does not take into account the trades with increased spread due to liquidity holes as the ones mentioned above.

It is clear traders need to be conscious of this huge amount of money they give away to their broker and try to optimise it.

Measures to Cost Reduction

Use of Limit Orders

Define clearly your desired entry and exit points. The use of limit orders technically does not eliminate the spread, but the use of limit orders allows the trader a clear definition of the entry price or exit price. Limit orders are also handy on low liquidity conditions or liquidity holes due to volatility produced by unexpected news. Therefore, its use is recommended in entry orders and take profits.

The use of stop-limit orders instead of stop-loss orders is not recommended, though, because stop-loss order is issued to protect the account against unwanted market movements, and the use of a stop-limit order does not guarantee that the order is taken.

Move your trading activity to a higher time-frame.

Trade costs and profits are timeframe dependent. The shorter the timeframe, the smaller the profits, but the larger the costs of the trade, due to the increased number of trades. Therefore timeframes below 1H are not recommended due to the high costs and reduced benefits.

Limit your trades to the most active assets

We have seen that spreads go larger as the pair is less active, therefore limiting the activity to the most liquid assets is a way to reduce costs.

Stop your trading activity near economic announcements

Keep an eye in the economic releases of the day and stop your activity on the assets related to the event ten minutes before the scheduled data release. That will take you out of most of the liquidity-related troubles.

Broker negotiation

A trader generating from 8k to 25K commission is a goldmine for a broker. Therefore, the first measure is to talk to the broker and negotiate a change in the account conditions. Switching to an ECN Account as a first measure. It would be desirable a negotiation on the overall conditions to lower these costs, and if the broker is not willing to that, search for a cheaper broker.

 

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