Wednesday, February 20, 2008

Profit Target and the Spread

Some online forex brokers now offer 3 to 5 pip spreads in the liquid currencies such as EUR/USD and USD/JPY. These are very competitive prices which a few years ago were unthinkable. As recently as the mid 1990's brokers were quoting 10 pip spreads in the major currencies plus a commission! Thankfully due to the internet, the current boom in Forex trading and the competition between Forex brokers, those days are well and truly over.The excellent value available from trading on tight spreads works very much to the traders advantage. However, some recomend that you avoid overtrading and entering trades for just a 5-10 pip profit or loss. Even trading this way on 3 pip spreads can adversely affect your profitability.

Below are examples of both a winning trade and losing trade when trading for a 10 pip profit or loss:

Winning Trade:
Buy EUR/USD at 1.2020 (price = 17/20)Sell EUR/USD at 1.2030 (price = 30/33)
Market moves 13 pips before taking profit

Losing Trade:
Buy EUR/USD at 1.2020 (price = 17/20)Sell EUR/USD at 1.2010 (price = 10/13)
Market moves 7 pips before taking loss

The above example highlights that the risk/reward of trading for a 10 pip profit or loss is poor. For the same 10 pips P&L, the market must move 13 pips for your winning position, but only 7 pips for your losing position. As a general rule of thumb, Take-Profit or Stop-Loss levels are recommeded by some as at least 10 times the spread you have traded on. This strategy will (should) help avoid overtrading and improve risk/reward. This is being considered in my current system where I aim to take a profit at 10 pips.

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