Prop firm challenges exist to evaluate a trader's performance, discipline and risk management. Many beginning traders concentrate their efforts on finding market direction and setting profitable targets. What is more, spreads do not come into play for many people. Nevertheless, this one variable can significantly influence your challenge outcome.
The knowledge of spreads is crucial due to the fact that even the smallest spreads may significantly reduce trader's earnings over time. Moreover, spread will be of high importance for those traders who are required to operate under drawdown limitations and target their profits. This article explains the importance of spreads in prop firm activities and how to use this formula:
What is a Trading Spread?
A trading spread is the gap between the bid price and ask price in a particular currency pair. A bid price represents what the buyer wants to buy, whereas the ask price represents what the seller is demanding.
For instance:
- Bid Price EUR/USD = 1.1050
- Ask Price EUR/USD = 1.1052
- Trading Spread = 2 pips.
This gap is the cost that a trader pays when using the service offered by the brokerage or prop firm platform. Even if the trade goes profitable, the trader will have to cover the spread cost first.
It is vital to understand how spread can be calculated in the foreign exchange market.
The Importance of Spreads in Prop Firm Challenges
Prop firm challenges typically involve strict guidelines like the following:
- Daily drawdown caps
- Overall drawdown cap
- Trading days minimum
- Profit goals
Due to such requirements, each pip counts. Spreads make trading more expensive and can make it challenging to meet the profit targets.
For instance, in case the prop firm challenge calls for a 10% profit goal, the cost associated with high spreads will negatively impact the profitability. The trader might think that his or her approach works well while, in fact, profits gradually erode.
This point is particularly relevant to scalpers and day traders making several trades every day.
How Spreads Lower Returns
The starting point for all trades is that the initial trade will make a loss because of the spread. In case a trade is opened long, then the market should move sufficiently far to cover the spread so that it makes profit.
Consider an illustration below:
- Spread = 2 pips
- Return on each trade = 10 pips
A total move of 12 pips is required to earn the 10 pip return.
text{Trade Required Movement} = text{Return on Trade} + text{Spread}
In case many trades are carried out daily, the losses will be compounded.
Assume:
- Number of trades per day = 10
- Average spread cost = 2 pips
- Total spread cost per day = 20 pips
On a monthly basis, the spread cost becomes enormous.
Calculating Spread in Forex Market
Many novice traders often wonder how to calculate spread in forex. This task is easy to perform.
Calculate spread using the following equation:
- text{Spread} = text{Ask Price} – text{Bid Price}
- Illustration:
- Ask Price = 1.2045
- Bid Price = 1.2042
- Spread = 0.0003 = 3 pips
It is common practice for many popular currency pairs to express their spreads in pips. Generally, one pip is the fourth decimal point in forex trading.
The smaller the spread, the less expensive the transactions become.
Fixed Spreads vs Variable Spreads in Challenges
Prop firms can provide traders with either fixed spreads or variable spreads.
Fixed Spreads
Fixed spreads do not vary irrespective of market conditions. Traders enjoy stable trading fees.
Advantages:
- It is easier to calculate risks
- Stable fees during regular trading hours
- Suitable for novice traders
Drawbacks:
- Occasionally bigger than variable spreads in calm markets
Variable Spreads
Variable spreads vary based on market volatility and liquidity.
Advantages:
- Very narrow spreads during busy market hours
- Low fees during stable market conditions
Drawbacks:
- They can widen considerably during news announcements
- Challenges are more difficult for traders with variable spreads.
Spreads Affected by News
News events can have a significant effect on spreads. Examples of such events include:
- Non-Farm Payrolls (NFP)
- Interest Rate Decision
- Inflation data
- GDP data
These can increase spreads from 1 pip to 10 pips or more for short periods.
This causes several issues:
- Positions get closed much earlier
- Unusual triggering of stop-loss orders
- Reduced profit margins
- Drawdown limits reached very quickly
Most traders are unable to pass tests just because they fail to factor spread widening during volatile hours.
Ideal Forex Trading Sessions With Narrow Spreads
The spreads in forex markets are always low in trading sessions that have high liquidity.
The best trading sessions are:
London Session
The London forex session has huge volumes of transactions and small spreads.
New York Session
The combination of the London and New York sessions will provide you with the lowest spreads each day.
Low Liquidity Hours Should Be Avoided
Trades executed during rollover hours or late Asia sessions may experience wide spreads.
Spreads' Effect on Scalpers and Scalping Systems
Scalpers are significantly influenced by spreads since they try to make small gains.
For instance:
- Target = 5 pips
- Spread fee = 2 pips
Spread costs amount to 40% of the profit from the start.
Swing traders have little effect on this since their targets are higher gains.
This explains why most prop firms limit scalping systems.
Risk Management and Spreads Knowledge
One of the most valuable skills that a trader needs in prop trading is risk management. In all trade calculations, traders need to take into account:
- Size of the stop loss
- Risk/reward ratio
- Entry into the trade
- Target profit
For instance, when a trader takes a 10-pip risk but there is a 2-pip spread, then the trader’s actual risk exposure is 12 pips.
text{Risk Exposure} = text{Stop Loss} + text{Spread}
Selecting the Right Prop Firm or Broker
It’s worth noting that different prop firms may not have the same trading terms.
Prior to participating in the contest, a trader needs to evaluate the following criteria:
- Average spreads on major currency pairs
- Commission policy
- Execution speed
- Level of slippage
- Stability of the trading platform
Narrow spreads can significantly impact performance through hundreds of transactions.
However, this criterion becomes crucial for those trading via the instant funded account since real money is at stake right from the start.
Instant Funded Accounts and Spreads Efficiency
In an instant funded system, traders have the option to fund their capital without going through a tedious evaluation period. In contrast, spread control becomes increasingly critical in instant funded accounts.
Due to the fact that traders start off with live trading right from the get-go:
- Trading expenses impact payouts directly
- Spread inefficiency can make consistent profits difficult
- Wide spreads can cause unanticipated losses
Successful traders in an instant funded account prioritize efficient trading environments.
Ways to Minimize Spread Costs
Some useful tips for minimizing costs associated with spreads include:
Trading Large-Cap Pairs
These pairs tend to have lower spreads, such as EUR/USD and GBP/USD.
Do Not Trade When There Are News Announcements
Spreads tend to increase when there are news announcements.
Careful use of Limit Orders
They are effective in reducing bad trades.
Trading at High Liquidity
The London-NY time zone is ideal.
Selecting Low Spread Prop Firms
Low spreads mean better profit margins in the long term.
Conclusion
Spreads are the aspect that is largely underestimated when it comes to the issues faced by prop firms. While some traders think only about strategy and psychological skills, spread always decreases profitability on each transaction.
Knowing the basics of calculating spreads in forex gives traders an opportunity to determine their trading costs better and manage risks. Having lower spreads can be helpful when trying to pass challenges, keep within drawdowns and conduct regular trades.
For those traders who trade in instant funded accounts, controlling spread expenses is critical because they affect the results of operations significantly.
In general, traders with good knowledge about spreads have much higher chances of passing prop firm evaluation tests.
