Which Pairs to Trade

Spreads play a significant factor in profitable forex trading. When we compare to the average spread to the average daily movement many interesting issues arise. Namely, some pairs are more advantageous to trade than others. Secondly, retail spreads are much harder to overcome in short-term trading than some may anticipate. Third, a "larger" spread does not necessarily mean the pair is not as good for day trading when compared to some lower spread alternatives. Same goes for a "smaller" spread - it does not mean it is better to trade than a larger spread alternative.

Establishing a Base Line
To understand what we are dealing with, and which pairs are more suited to day trading, a base line is needed. For this the spread is converted to a percentage of the daily range. This allows us to compare spreads versus what the maximum pip potential is for a day trade in that particular pair. While the numbers below reflect the values in existence at a particular period of time, the test can be applied at any time to see which currency pair is offering the best value in terms of its spread to daily pip potential. The test can also be used to cover longer or shorter periods of time.

These are the daily values and approximate spreads (will vary from broker to broker) as of April 7, 2010. As daily average movements change so will the percentage that the spread represents of the daily movement. A change in the spread will also affect the percentage. Please note that in the percentage calculation the spread has been deducted from the daily average range. This is to reflect that retail customers cannot buy at the lowest bid price of the day shown on their charts.

• EUR/USD
  Daily Average Range (12):105
  Spread: 3
  Spread as a percentage of maximum pip potential: 3/102= 2.94%
  
  
• USD/JPY
  Daily Average Range (12):80
  Spread: 3
  Spread as a percentage of maximum pip potential: 3/77= 3.90%
  
  
• GBP/USD
  Daily Average Range (12):128
  Spread: 4
  Spread as a percentage of maximum pip potential: 4/124= 3.23%
  
  
• EUR/JPY
  Daily Average Range (12):121
  Spread: 4
  Spread as a percentage of maximum pip potential: 4/117= 3.42%
  
  
• USD/CAD
  Daily Average Range (12):66
  Spread: 4
  Spread as a percentage of maximum pip potential: 4/62= 6.45%
  
  
• USD/CHF
  Daily Average Range (12):98
  Spread: 4
  Spread as a percentage of maximum pip potential: 4/94= 4.26%
  
  
• GBP/JPY
  Daily Average Range (12):151
  Spread: 6
  Spread as a percentage of maximum pip potential: 6/145= 4.14%

Which Pairs to Trade
When the spread is placed into percentage terms of the daily average move, it can be seen that the spread can be quite significant and have a large impact on day-trading strategies. This is often overlooked by traders who feel they are trading for free since there is no commission.

If a trader is actively day trading and focusing on a certain pair, making trades each day, it is most likely they will trade pairs that have the lowest spread as a percentage of maximum pip potential. The EUR/USD and GBP/USD exhibit the best ratio from the pairs analyzed above. The EUR/JPY also ranks high among the pairs examined. It should be noted that even though the GBP/USD and EUR/JPY have a four-pip spread they out rank the USD/JPY which commonly has a three pip spread.

In the case of the USD/CAD, which also has a four-pip spread, it was one of the worst pairs to day trade with the spread accounting for a significant portion of the daily average range. Pairs such as these are better suited to longer term moves, where the spread becomes less significant the further the pair moves.

Adding Some Realism
The above calculations assumed that the daily range is capturable, and this is highly unlikely. Based simply on chance and based on the average daily range of the EUR/USD, there is far less than a 1% chance of picking the high and low. Despite what people may think of their trading abilities, even a seasoned day trader won't fair much better in being able to capture an entire day's range - and they don't have to.

Therefore, some realism needs to be added to our calculation, accounting for the fact that picking the exact high and low is extremely unlikely. Assuming that a trader is unlikely to exit/enter in the top 10% of the average daily range, and is unlikely to exit /enter in the bottom 10% of the average daily range, this means that trader has 80% of the available range available to them. Entering and exiting within this area is more realistic than being able to enter right in the area of a daily high or low.

Using 80% of the average daily range in the calculation provides the following values for the currency pairs. These numbers paint a portrait that the spread is very significant.

• EUR/USD
  Spread as a percentage of possible (80%) pip potential: 3/81.6= 3.68%
  
  
• USD/JPY
  Spread as a percentage of maximum pip potential: 3/61.6= 4.87%
  
  
• GBP/USD
  Spread as a percentage of possible (80%) pip potential: 4/99.2= 4.03%
  
  
• EUR/JPY
  Spread as a percentage of possible (80%) pip potential: 4/93.6= 4.27%
  
  
• USD/CAD
  Spread as a percentage of possible (80%) pip potential: 4/49.6= 8.06%
  
  
• USD/CHF
  Spread as a percentage of possible (80%) pip potential: 4/75.2= 5.32%
  
  
• GBP/JPY
  Spread as a percentage of possible (80%) pip potential: 6/116= 5.17%

With the exception of the EUR/USD, which is just under, 4%+ of the daily range is eaten up by the spread. In some pairs the spread is a significant portion of the daily range when factoring for the likely possibly that the trader will not be able to accurately pick entries/exits within 10% of the high and low which establish the daily range.