Top Trading Mistakes – Misunderstanding Spreads

I tell all our traders that Spread and Slippage are two guaranteed realities of trading the markets. Even when you think you have “RAW ECN” spreads with brokers promising spreads from 0.00, there’s no such thing as “No Spread”.

In this, much needed article, I will attempt to clarify the issue of spread.

Before I start, let me take a moment to explain what causes the spread to exist in the first place. For the length of this article, I will focus on the STP broker model and not go into what goes on with B-Book brokers, market makers and dealing desk brokers as far as spreads are concerned.

In an STP broker model, we “buy” liquidity from liquidity providers such as Tier 1 banks. Depending on the footprint of the bank, they may either buy their liquidity from another partner bank or create the liquidity in-house (whereby they will warehouse certain risk for each trade). Either way, Tier 1 banks always pass the price to an STP broker with a spread already built into the price. This spread varies from bank to bank which is why, if you try to compare the close of Week 1 against Broker A, it may or may not match with the close of the same week with Broker B – this is because the liquidity source may have been different and a price difference (albeit minuscule) is possible.

Not all Tier 1 banks operate an ECN clearing base, which makes it very difficult for a trader to ascertain whether or not the raw ECN spreads they are getting are indeed RAW and are not marked up in between. This, however, is inconsequential for the most part because as a trader, your focus should never be on the 1 point or 2 point spread. Why? Because even if you have 0 spread at any one time, it never remains that way and it always… with utmost certainty, at some time during the day fluctuate to a few points here and there. If your strategy is based on “0” spread, you’re only setting yourself up for a giant fall because 0 spread is a rare phenomenon and only lasts a few seconds at a time.

Raw ECN Spread Vs ECN Spread Vs Retail Spread

I’m sure many of you have come across all these terms. They are not much different, one from another, except in the assurance of how wide spreads might go at any given time.

RAW ECN spread?This is typically (read consistently) around 1 or 2 points for FX Majors. During high volatility, they can go up to 7-9 points but rarely will ever cross the 1 pip line for spread, unless there’s a huge amount of uncertainty in the market. RAW ECN spreads always come with a commission element of $x per lot traded. When you factor in the commission element, your overall cost of trading nullifies any advantage you may have gained from having raw spreads.

ECN Spread?This is typically higher than RAW ECN spread but provides more consistency in spread gaps in the market. Typically, for FX Majors, you will most likely see spreads around 4 or 6 points with volatility pushing it out (at times) to around 1.1 but never higher than 1.5, unless there’s a major market event underway. There’s a commission element in these type of spreads too but somewhat lower than typical commissions applied on RAW ECN spreads. At Manhattan Global Markets, we have a ZERO commission policy on ECN spreads.

Retail Spread?This typically starts at around 1 pip and can go all the way into 3 or 4 pips depending on the broker you’re dealing with.

What causes spreads to increase

Market volatility, uncertainty, risk and of course market sentiment are the primary contributors to spreads getting wider. However, it is important to understand that in 90% of the cases, spreads are widened by the liquidity providers and the STP broker is simply passing it to you. Most STP brokers, including Manhattan Global Markets, don’t have the necessary technology needed to arbitrarily widen spreads outside of LPs widening their spreads. These are much easier to do with virtual dealer plugins and by manipulating price data feed at the bridge level. So the 10% of the cases when spreads aren’t widened by the LP, its being done by those dirty brokers who claim to be STP but are manipulating the price feed before sending the quotes to your terminal.

What is the right spread?

Frankly, if I speak to you as a trader, I would say that with my style of algorithmic trading, my strategies achieve great results with spreads below 1 pip at any given time. I don’t need zero spreads, especially if it comes at a high commission. Given the choice between spread and commission, I would much rather take a low spread + zero commission option because it does not mess with my trading calculations.

The market has somewhat educated traders to ask for raw ECN spreads and then haggle on the commission element for every penny. Brokers need to make money too and the more you let them make money on a reasonable spread, the less likely they are to try to find other ways to make money from you. Read this last statement as a precursor into understanding the mindset of a B-Book broker.

B-Book brokers will gladly offer you zero spread, low commission and instant execution because they have no intentions of letting you keep any of those savings. Get wiser, accept the reality of trading the markets. Spreads are a necessary component of maintaining healthy trading conditions… Much like the Goods and Services TAX (GST) or Value Added Tax (VAT) charged by many governments, you should consider spread as merely a cost of trading the markets.

About
After having traded the markets for years and years, I got fed up of the skullduggery that I witnessed among brokers and decided to do something about all this injustice. Manhattan Global Markets is my initiative to provide good traders a great brokerage service.

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