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Why are we seeing wider spreads in FX?

Thu, Sep 25 2008, 09:53 GMT
by Betsy Waters

dbFX.com from Deutsche Bank

The credit and stock markets have been boiling over recently and especially over the last 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% 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.

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% 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 10 pip bid offer spread. Keep in mind that the value of a pip on a 100K lot is approximately the same for EUR/USD and CAD/JPY, so the value of the 2 pip spread in EUR/USD is really five times more than a 10 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 I used the term “normal market conditions”. While frequently used in FX the last few days show we are not in normal market conditions. As I said above EURUSD normally trades at one to two pips on most FX platforms but last week we saw spreads trading at 3 to 5 pips.

Why are spreads so wide?

The credit markets problems are spilling into the FX markets, as the major interbank players have less credit to lend to smaller institutions. As a result there are fewer players in the interbank 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 you will see thinner markets with wider spreads.

Under current economic conditions you will also see a choppier market, as interbank 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 interbank 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 so wide? Well, they are a direct reflection of the global credit markets. Remember that the rolls 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 interbank market is charging very high short term rates which cause roll rates to be unusually skewed. In fact, Interbank 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 the 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, our traders 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 1 US Dollar for every 1.5 US Dollar 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 not so well). As you trade more, you will develop your own trading parameters for how much risk to take.

So go forth and go conquer. Despite what’s happening on Wall Street, there’s no reason why you still can’t find bargains in the currency markets if you carefully manager your positions.

Published on  Thu, Sep 25 2008, 09:53 GMT

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