Leverage and spreads are important for forex scalpers, but their attitude and preferences and the broker they are working with are also equally important. In simple terms, it is the broker that makes or breaks the scalping strategy employed by traders. This is to say that scalpers have control over the strategies they use, stop loss levels they set, profits they make and timing of their trades, but they have no control over matters like spreads, server stability and attitude of brokers towards scalping.
Hundreds of brokers are out there in the market and their technical capabilities and business models are different. Though these differences matter a little to swing traders, they are not at all significant as far as long term traders. However, they impact the performance of day traders and scalpers. At the basic level, the spread can be considered as tax paid on profits made and losses incurred to the broker for the services provided.
How Spread Affects Scalpers
Traders who do not use the scalping strategy and other day-trading strategies often open and close one or two positions during the course of a trading session. Though the cost of the spread offered is an important factor, a successful trade easily justifies the fee paid to brokers. However, the situation is different in the case of scalpers. This is because scalpers open and close a number of positions in a day. The cost of the trades becomes a significant factor.
The concept is best explained with the help of an example. Imagine that a scalper is opening and liquidating 30 positions in a trading session in the currency pair EUR/USD pair. Typically, the spread is about 3 pips. Also, assume that the trade sizes are the same and 66 percent of the positions returned profits of 5 pips each to the trader. Let us also assume that the trader incurred a loss of 3 pips per each of the trades that ended in the red. Excluding the cost of the spread, the net gain/loss made by the trader can be computed as follows:
(Positions that returned profits) – (Positions that returned losses) = Net profit/loss
In this example, 20 positions (two-third) returned profits and 10 positions (one-third) returned losses to the trader. Therefore,
Net profit earned by the trader is (20 × 5) – (10 × 3) = 70 pips
Now, if the cost of the spread is included, the formula to be applied is
(Positions in black) – (Positions in red + Cost of the Spread) = Net profit/loss
Applying it to the trader’s situation,
(20 × 5) – (10 × 3 + 30 × 3) = – 20 pips
This shows that the trader finished the session with a net loss even though the number of profitable trades was double the number of loss making trades and the average gain was more than the average loss. This is to say that in spite of the trader’s remarkable track record, the scalping activity returned a net loss to him. In order to just negate his losses, he would have to make a net profit (on average) of 9 pips per trade, assuming that all other factors remain the same.
Now, consider another situation wherein the spread is just 1 pip in the same currency pair. Other conditions such as gain and loss remain the same at 5 and 3 pips each.
The net profit made by the trader, including the cost of the spread, in this scenario would be as follows:
Net profit = (20 × 5) – (10 × 3 + 30 × 1) = 40 pips
The large discrepancy in the outcome of the two situations can be attributed to the payment to be made to the broker for each and every position opened by the trader. Irrespective of whether the trader makes profit or incurs loss, the brokerage house has to be paid a fee for the services provided.
This clearly shows that lowest spreads forex brokers are best suited for scalpers. Of course, traders should choose brokers that offer the lowest spreads for the currency pairs that they want to trade in. It, therefore, goes without saying that scalpers must thoroughly scrutinize the account packages offered by forex brokers prior to deciding to work with one of them.
Forex Brokers’ Scalping Policy
Though most of the well-established forex brokers, those with a history and a large client base, have a policy for facilitating scalpers, many do not encourage scalping traders. Some others make scalping an unprofitable activity for traders. In order to understand the logic behind the stance taken these forex brokers, it is important to understand as to how they net out on clients’ positions prior to passing them on to the banks.
Imagine a situation wherein a broker’s clients are all losing money during trading. Assume that the losses are very high and the margin calls triggered in the case of some of the traders are not met. Forex brokers are liable to compensate the banks that provide liquidity. Forex brokers often net out by trading against the clients’ positions so as to prevent the occurrence of such a situation. This is to say that the forex broker takes a short position when a client takes a long position and vice versa. As the positions oppose each other, the total exposure to the market becomes zero. This resolves the liquidity issue for the brokers and the brokerage firm will not be impacted in any manner whatsoever by the profits or losses returned to traders’ accounts.
Scalpers disrupt this plan of brokers by placing several trades of different sizes, often at awkward times. This forces brokers to commit their own capital at times. Additionally, the system gets bombarded with trades. If the servers of the broker are not fast enough, the situation deteriorates further.
All these point to the fact that scalpers must work only with competent, innovative and technologically advanced brokers. This is to say that a no-dealing desk broker is the right broker for a scalper.