To be frank, traders don’t care much about the spread after comprehending what it means. Isn’t the spread just something that exists without thinking too much? One or two pips are irrelevant, really.
However, in prop trading firms where drawdown limits are stringent and precise, such an attitude may lead to significant losses. Indeed, spread not only influences how traders trade but also how they handle risks in the process. Thus, it’s high time to explore the connection between spread and risk management thoroughly. Let’s see in detail How to Calculate Spread in Forex and it affects your risk management.
The Often Overlooked Connection Between Spread and Risk
On a superficial level, risk management involves:
- Determining position size
- Setting stops
- Calculating risk/reward ratio
What traders often forget, however, is that the spread plays an essential role in all those areas.
As soon as one places a new trade, they immediately face a loss equal to the spread value. In other words, one's "actual" entry into the trade happens at a price lower than what's displayed on the chart.
Hence, failure to consider this aspect results in inaccurate calculations.
How Spread Impacts Your Stop-Loss (More Than You Think)
Suppose that you're trading with a 10-pip stop loss.
Simple enough.
However, if the spread is 2 pips, then there are really only 8 pips of room left for your trade to be in profit.
And this is due to the fact that:
- You buy at the asking price.
- You sell at the bidding price.
And therefore, that difference is taken out of your room.
It is here that traders find themselves disappointed:
- The market just touched my stop loss and reversed!
- Yet chances are that the spread contributed to that disappointment
Step-by-Step: Factoring Spread Into Risk
Let’s walk through a simple example so you can see how this works in practice.
Scenario:
- Trade: Buy EUR/USD
- Ask price: 1.2002
- Bid price: 1.2000
- Spread: 2 pips
You want a 10-pip stop-loss.
What most traders do:
They set their stop loss at 10 pips below their entry point.
What really happens:
Due to the existence of the spread, the trade is stopped sooner than expected.
The intelligent approach:
Include the spread in your calculations.
Thus, instead of placing a stop loss at 10 pips below, you take into consideration:
- 10 pips (targeted risk)
- 2 pips (spread)
Your stop loss is now 12 pips away from the entry point, thus giving you the desired 10 pips risk.
Position Sizing: The Secret Influence of Spread
This is when it gets fascinating.
In calculating position size, you usually consider:
- Account balance
- Percentage risk
Stop-loss distance
However, if your stop-loss does not include spread, you end up with a miscalculated position size.
Consequently, it might result in:
- Exposing yourself to more risk than anticipated
- Encountering your maximum drawdown sooner
- Failure in prop trading firms’ evaluations due to unnecessary losses
Risk-to-Reward Ratio Isn’t What You Think
Consider a case where you would like to have a risk/reward ratio of 1:2:
- Risk = 10 pips
- Reward = 20 pips
Seems like a good plan on paper.
However, when the
- spread is 2 pip
- Actual risk = 12 pips
- Actual reward = 18 pips
That is not a 1:2 ratio anymore; it is a less favorable ratio.
This is an example of a minor inefficiency that can slowly erode your trading performance.
Why This Matters More in Prop Firms
Whereas an inefficient trading account will not be a problem in itself for an ordinary trader, it is certain to become something else entirely for a prop trader.
This is due to the fact that there is:
- The necessity to consider daily maximum drawdowns
- Maximum losses guidelines should be adhered to
- Strict evaluation should take place
It means that even minor oversights such as failing to include the spread will lead to:
- Violation of guidelines
- Margin reduction
- Inconsistencies
Especially when trading aggressively or using tight stops.
Connecting the Dots: Calculation + Execution
Every trader sooner or later finds themselves looking for "How to Calculate Spread in Forex" and discovers the formula. But the key is using it to manage risk.
As a forex funded account Manager, you must move past merely entering and exiting trades.
Instead, you must consider:
- How does the spread influence my stop loss?
- Is my position size truly risk-appropriate?
- Are there any other factors affecting the spread?
These are the kinds of considerations that keep you in business for the long run.
The Right Spread Conditions Will Immediately Impact Your Risk Level
And here’s a mistake many traders make.
The spread isn’t always consistent; it will vary depending on:
- Market liquidity
- Time of day
- News events
Maybe you planned your trade with a 2-pip spread… but then it doubles to 6 pips.
Your entire risk strategy is now out the window.
So, professional traders do the following:
- They avoid trading during important news events
- They check spread conditions before trading
- They adapt their strategies to the current market conditions
A Simple Adjustment That Makes a Big Difference
Always do the following prior to executing any order:
- Determine the current spread
- Calculate it into your stop loss
- Size up your position if necessary
It only takes a few seconds but ensures that your trade reflects reality rather than theory.
Problems That Inevitably Affect Prop Traders
No sugarcoating here—the mistakes traders often make include the following:
- Neglecting spread when using small stops
- When you have a narrow stop, spread is very important.
- Placing orders at peak spread times
- A news release might change your risk overnight.
- Making assumptions regarding spread consistency
If the spread was small before, it doesn’t necessarily mean that it is currently so.
Final Thoughts
Spread might sound trivial, but when it comes to prop firm trading, even trivial things can be critical.
When you include spread calculation in your risk management system, there is one thing that happens – everything changes. Your positions are now more precise. Your assumptions become closer to reality. Most importantly, you prevent potential losses that could have otherwise occurred.
This is not about complicating your trading; rather, it is about tying the loose strings.
Since you live in the world where even one pip matters, the importance of spread calculation becomes obvious.
