In this article you will find an explanation of why we see volatility and wider spreads in the market. Portions of this article were written by Brandon Butler, A trade specialist for Interbankfx. 10/31/2008
The credit and stock markets have been boiling over with activity recently, and especially over the past few days. This volatility is also clearly evident in the forex markets, where we are seeing wider spreads on spot prices and roll-over rates. Spreads are perceived as a charge by the broker or bank, but this is not 100 per cent accurate. The bid-offer spread is a reflection of the liquidity in the overall market, not just one bank’s liquidity. The more players in a particular market the narrower the bid-offer spread.
Liquidity will affect the quality of the bid-offer spread in different time zones and by currency pairs. As you may have noticed in the London time zone, when we have the best liquidity, spreads are narrow, and in the early Asia time zone when markets are very quiet, you will find wider spreads. Spreads will widen many time when there are news announcements of interest to the currency market. The amount the spreads widen will depend on the announcement. Some News announcements will not affect the market and other announcements will cause huge movements in the market.
To see how liquidity will affect the spread by currency pair, we can use the BIS data as a benchmark. The EUR/USD is the most active currency pair with 37 per cent of the market, and has the tightest bid-offer spread of one to two pips in normal market conditions. Conversely, a pair such as CAD/JPY normally has a 10-pip bid-offer spread.
Keep in mind that the value of a one pip trade on a 100k lot (on a standard account) is approximately the same for EUR/USD and CAD/JPY, so the value of the two-pip spread in EUR/USD is really five times more than a ten-pip spread in CAD/JPY. This shows that there are substantially fewer players in CAD/JPY than in EUR/USD. I know this sounds intuitive but this dramatic example draws out the relationship between the liquidity in a currency pair and the spread.
You will have noticed that I used the term ‘normal market conditions’. While frequently used in FX, the past few days show that we are not in normal market conditions. As I said above, EUR/USD normally trades at one to two pips on most FX platforms, but last week we saw spreads trading at three to five pips.
Why are spreads so wide?
The credit market problems are spilling into the FX markets, as the major inter-bank players have less credit to lend to smaller institutions. As a result, there are fewer players in the inter-bank market, reducing the overall liquidity in the market, and leading to wider spot spreads. Similar to the example relating to time zones, in the usually more active deep time zones (when more than one market is open i.e. the US and European or the Asian, and Australian markets are open at the same time) you will see thinner markets with wider spreads.
Under current economic conditions you will also see a choppier market, as inter-bank traders will tend not to hold positions for very long. In the past, when a large order came into a bank, the trader would hold the position and then slowly trade out of it, thereby smoothing the market reaction to the large order. Currently, the inter-bank traders are moving much more quickly to square their positions, so one large order can create a short-term move in the market. In these cases, the retail trader will see a choppy market with 50 or so pip movements in one quick flow.
But why are the rolls prices (spreads) so wide? Well, they are a direct reflection of the global credit markets. Remember that the rolls (spreads) are costs or earnings for holding a position overnight. When you buy currency you are borrowing, and when you sell currency you are lending, so when trades are rolled you either earn or pay the net of the two interest rates.
In this market, however, the short-term rates, overnight lending and borrowing rates are unusually volatile and high. This is due to the uncertainty in the market over the day-to-day conditions of the credit quality of market participants. Therefore, the inter-bank market is charging very high short-term rates that cause roll rates to be unusually skewed. In fact, Inter-bank rates are so skewed that you may end up paying interest on both long and short positions on the same currency pairs.
A tip for trading in volatile markets: plan your trades carefully
With such volatile markets it is even more important to manage the risk of your trading as much as managing the direction of your trades. You must carefully plan your trade before you make it.
In your plan, you need to set key entry and exit levels for when you will buy a currency pair and also when you will sell it. You should have two exit points in mind, one for profits and one to stop your losses. For short-term trades, a trader will typically have a risk/reward ratio (the amount of loss they are willing to take to make an amount of profit) of 1 to 1.5; longer-term trades with a strong conviction may have a risk/reward ratio of 1 to 2. In other words, for a trade with a 1 to 1.5 risk/reward ratio, you risk losing US$1 for every $1.5 you make.
This planning extends to post-trading as well. It is useful to keep notes on each trade and review your pre-planning and how you did on each trade to see what you did well (and what you did not so well). As you trade more, you will develop your own trading parameters for how much risk to take.
Despite what’s happening on Wall Street, there’s no reason why you still can’t find good trades in the currency markets if you carefully manage your positions and time your entries. Find a treand on a larger time frame and enter the trade in the direction of the trend on a smaller time frame. Wait for the signals to be confirmed before you enter. You may also wait until the market settles down then come back and trade.