This article will show you the best forex spread trading methods and important tips traders should use to protect themselves from a growing spread.
The forex spread is the gap in price between the bid (sell) and the ask (buy) price. The spread can increase and decrease depending on various factors, which we will explain soon.
BEWARE OF INCREASING SPREADS
Forex traders must keep an eye on the spread, as it is the primary cost of trading. A wider spread results in higher trading expenses.
Volatility or illiquid currency pairs with leverage can be dangerous for forex traders. Keep in mind that the more leverage you use, the higher the spread cost will be relative to your account equity. It's best to use little or no leverage.
New traders should be particularly cautious of the spread. If your account is small and you take a relatively large position, the spread may widen, resulting in a margin call or even a closed position.
To ensure successful FX trading, beginners can learn the basics by using these three spread trading techniques and strategies: monitoring factors that affect the spread, the currency pair's liquidity, and the time of day.
1) MONITOR FACTORS THAT INFLUENCE THE SPREAD'S WIDTH
Traders should be aware of the following factors to avoid high spread costs due to a widening spread:
Volatility: Market volatility caused by economic data releases or breaking news events can cause the spread to widen.
Liquidity: A lack of market liquidity can also lead to a wider spread. Liquidity and volatility are closely related. Illiquid currency pairs, such as those from emerging markets, are known for their high spreads. Illiquid markets can also cause volatility.
Spreads and news events: Liquidity providers may widen their spreads before major news events, such as the release of NFP employment numbers, to mitigate some of the risk associated with the event.
The spread usually returns to its average level after a few minutes, so it's best for traders to wait and trade only when the spread narrows.
2) SELECT FOREX PAIRS WITH HIGH LIQUIDITY
Many traders, especially beginners, use the strategy of choosing forex pairs with high liquidity to trade. Under normal conditions, pairs with high liquidity have lower spreads.
Major currency pairs, such as EUR/USD (Euro Dollar), USD/JPY (Dollar Yen), GBP/USD (Pound Dollar), and USD/CHF (Dollar Swiss Franc), have the lowest spreads among all currency pairs because they are traded in large volumes.
However, these currencies do not always have low spreads, as they can be affected by volatility, liquidity, and news events, which can cause spreads to widen.
Emerging market currencies, such as USD/MXN (US dollar/Mexican Peso), USD/ZAR (US Dollar/South African Rand), and USD/RUB (US Dollar/Russian Ruble), generally have higher spreads compared to major currency pairs. As a result, it's wise for traders to use less or no leverage when trading these pairs.
In the image below, the black boxes indicate the spread of certain currencies. The major market currency pairs, USD/JPY and EUR/USD, have narrow spreads of 0.7 pips and 0.6 pips, respectively.
On the other hand, the emerging market currencies, USD/ZAR and USD/RUB, have extremely wide spreads of 90 pips and 1000 pips, respectively.
3) CONSIDER THE TIME OF DAY WHEN TRADING
Forex spreads are influenced by the time of day, so it can be helpful to factor this into your trading strategy. During major market trading sessions, such as London, New York, Sydney, and Tokyo, forex spreads are typically at their lowest due to the high volume of trades.
To take advantage of narrower spreads, forex traders could trade during these times. When the London and New York sessions overlap, spreads can become even narrower.
The hours shown below are in Eastern Time. The London and New York sessions overlap between 8am and 11am Eastern Time.
Other factors can also affect the best time of day to trade forex.
An example of spread trading using USD/JPY
By using various spread trading techniques, you can minimize the risk of trading with a high spread. It's important to keep in mind that the spread may change between the time you open and close a position.
Let's consider a simple example with USD/JPY, one of the major currency pairs with high liquidity and low spreads.
Monitor factors that could impact the spread
When trading USD/JPY, it's important to stay informed about any events or data releases that could affect the spread. You can do this by keeping up with current news and using an economic calendar.
The economic calendar below shows events that could increase volatility and the spread. It's wise to trade around high impact events unless you're specifically trading the news event.
Some events that could increase volatility and the spread include:
- GDP releases
- CPI (inflation data)
- NFP (non-farm payrolls)
Take into account the time of day for trading
It's also important to consider the best time to trade USD/JPY, as it can be quite volatile. Generally, one of the most liquid times to trade forex is between 8am and 11am Eastern Time, when the London and New York sessions overlap. The USD/JPY is also highly liquid during the Tokyo session.
Emerging market currencies can have very large spreads when traded outside of their main market sessions. When trading these currencies, it's best to do so during their main market hours when they are most liquid.
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