How do you account for spreads?
Hello Traders, Thiru Nagappan here, founder of Master the Markets, Elite Traders Conference and The Traders Open Day.
Today we’re going to be looking at how you actually account for spreads. This is quite a common topic actually. Some traders think that it’s simple or it doesn’t really matter or they think they know what it’s all about. But there are some things that you do need to look into, especially if you’re an intra-day trader and especially if you’re a scalp trader as well, because spreads really do start to matter.
Of course if you’re an end of day swing trader or a position trader where you are trading for days, weeks or sometimes months, then it doesn’t matter as much. But regardless, it is really well worth knowing what it is because sometimes the common challenges that some traders have, especially the intra-day traders, is that they say the price actually reached their target level on the chart but it was not exited and it started to reverse and it hit the stop loss. That can cause lots of arguments with the broker and cause them to feel down about it. That sometimes is due to spreads.
First of all what you need to understand before we look at the question in detail is what is a spread? A spread is the difference in price between the buy and the sell price. For example, you go into a shop. The shopkeeper has bought a mobile phone for £400 and now he’s selling it to you for £450. There’s a difference. It has been marked up to make a profit of £50. That difference in price is what we call a spread. It’s the same thing in currency. Change the mobile phone in this example to currency. If you’re buying GBP and selling USD, the difference between the buy and sell price is the spread. That’s how brokers make their money. They put on their mark up and that is what their profit margin is. As you know, there’s not usually that much of a difference. Usually with major currency it’s only about one to two pips difference. The way the brokers really make most of their money is the volume. They need lots of traders trading through their platforms and their brokerage – that’s how they make most of their money.
Now that we understand what the spread is, the second part is the application. What I’m talking about here is to what orders do we need to apply the spread? There are only two types of orders that you can put in the market – buy orders and sell orders. Between the buy orders you can either have an entry order or you can have an order to get out of the market in terms of a stop loss. Likewise with the sell orders; you can have one to enter the market or as a stop loss. Usually if you’re entering as a pending order then that would usually be as a buy stop. Then as a stop loss it can also be a buy stop as well and that would usually be for a short order. For a sell order it’s usually a sell stop and the same sell stop can be a stop loss for a buy order. So a buy stop can be an entry to buy and the same buy stop can be a stop loss to sell. You all do remember that because when you put an order to sell live or a pending order then you immediately put a stop loss as a buy stop. The same order in which you enter into a trade can be used as a stop loss for a buy order. Because remember that the only way to exit any position if you’ve bought first is to sell it back. If you’ve sold first then it’s to buy it back on a short order. So they are the only two ways to exit.
Where do we add the spread to? We only add the spreads to the buy orders. That means either if you’re entering it to buy something or on your stop loss for a sell order. Either on the entry as a buy order or as stop loss for the sell order is where you would add the spread.
In summary the spread is added to the buy orders either as an entry or as a stop loss – that’s the critical thing. Not the sell orders.
The next thing is about if you have a target. The last thing I want to tell you is that the price that you see on the chart – why is it that some traders put a target, the price gets there but it’s still not out of the market? This is why. Let’s say you’re taking a short trade and you are looking to buy back. So you have a buy limit or a target. But of course to every buy order you need to put some spread on it because the price that you see on the screen is actually all sell orders. So if it’s showing 13500 actually the buy price is 13502. Therefore you can easily see that if your target was at 13400 it needs to get to 13398 for you to be exited out of the market. So when it reaches 13400 on the chart, it’s actually 13402 on the buy price. That’s why when it hits it on the chart you’re not able to get out, you’re locked in still. This is critical because within these few pips sometimes, as you know Traders, you might get onto the chart and then that quickly reversed and retraces and sometimes your stops are hit and all the profit that you had is unrealised and disappears. So this is not what you want.
That is explained now and how it’s all aligned to its target. The final thing I want to mention is the C+S. The S stands for spreads. Not only should you add the spreads to your orders, you should also add what we call a cushion (that is what the C stands for) or leeway. For example, if you want to put a buy stop order or even to enter into a trade, we usually give two pips leeway or cushion and on top we add a two pip spread. Sometimes on end of day strategies if you’re entering into really strong resistance, you can just use one pip cushion and a one pip spread depending on whatever your broker is offering for that particular currency in terms of spread.
Remember that when you have your final entry figure or final stop loss figure it’s very important to include a cushion and plus your spread. It’s very important in terms of stop loss because sometimes a trade can come – and I’ve seen this before – and the price can come so near to your stop loss and then it can reverse and if you don’t include the spreads and you don’t have a cushion you know what will happen Traders? It will just stop you out and go all the way down and hit your target. Or it will hit your stop loss and go all the way up and hit your target.
Please remember all this as it is critical stuff. Do remember the three points when you are accounting for spreads and looking to understand what spreads are all about. These are very critical to your final balance sheet, your net profit and loss in your trade journal and for a positive equity curve.
So that’s all from me. Until the next time, as we always say, stay disciplined, follow your trading plan and keep Trading Like a Master.
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