How to Avoid Being Stopped out when Spreads Widen
We've all been there, you put on a trade and it shows you some profit, then all of a sudden the spread widens considerably and your stop-loss is hit, causing you to lose money. A few seconds later the spread goes back to normal and the price quickly resumes its previous (profitable) trend, but you no longer have a trade on.
Or you've placed a buy stop order to open a new position if the price reaches x, it is triggered when the spread widens, but as soon as the volatility subsides the price returns to where it was before the chaos started, ie. much lower than x, so you now have a losing trade on your hands.
This trader lost a lot of money due to widening spreads...
This article will show you how to avoid having an opening or closing order prematurely filled, due to the spread widening during important news or off market hours, using the different order types provided by Dukascopy.
► Why do spreads widen/tighten?
In a well-functioning financial market, where prices are dictated by various market participants (and not by a single entity/market maker), instruments do not have fixed bid/ask spreads. Usually, the higher the liquidity, the lower the volatility, and therefore the tighter the spread. So highly liquid currency majors such as EUR/USD and USD/JPY have tighter spreads than exotic pairs such as USD/RUB or USD/ZAR.
However, even major pairs can experience wider than normal spreads during volatile periods, such as interest rates announcements, GDP reports, unemployment figures, to name a few examples. There will also be wider spreads during off market hours, when there is only a fraction of the participants in the market, so the liquidity is lower. This can be seen when the markets open for the Asian session, at 21:00GMT Sunday, for example.
► What happens when spreads widen?
Imagine that EUR/CHF is trading at 1.20104/1.20125 at the end of the Asian session, a spread of 2.1 pips, and that in a few minutes time the Swiss National Bank (SNB) will announce something important regarding the CHF peg with the Euro. The market sentiment is divided, some traders think the CHF will strengthen dramatically, others have the opposite opinion. The liquidity in the pair dries up seconds before the announcement and the volatility is extreme. This is reflected in the spread, which widens to 32.1 pips.
Normal spread Spread right before the announcement
When the spread increases the ask price goes up x pips, and the bid price goes down usually the same x pips (more or less), in our example 15 pips. So, even if the "middle price" remains static, you can have way lower/higher bid/ask prices respectively: 1.19954/1.20275. The SNB speech is not as important as the market assumed so the prices quickly return to normal, back to 1.20104/1.20125. Note that the "middle price" is always the same in this example.
► Buy " BID ≥ Stop" and sell " ASK ≤ Stop" orders
The vast majority of Forex brokers offer only a few order types: market, limit and basic stop orders. These basic stop orders to buy (either to open a position or as a stop-loss) are triggered when the market's ask price hits or breaches the price level specified (buy "ASK ≥ Stop"), and stop orders to sell are filled when the bid price hits or drops below the price level specified (sell "BID ≤ Stop").
Fortunately, Dukascopy gives us the possibility of indicating either bid or ask prices when we place stop orders, so we can have buy "BID ≥ Stop" and sell "ASK ≤ Stop" orders, and, as I will explain, this is a "must-have" feature when choosing a broker, as important as comparing spreads and commissions.
► How to correctly open a position
For the sake of simplify, this article assumes that you use bid prices as the default on your charts and trading strategies.
● Short position
Using the previous EUR/CHF example, imagine that you wanted to open a short position if the price dropped below 1.20000, so you had placed a sell stop order at 1.19999. If your broker offered only the normal stop orders which are triggered by the bid price, your order would have been filled at 1.19954 because the bid price did get below 1.19999. However, that was not a normal market price, so your trade is now showing a significant loss when things got back to normal.
To avoid this situation using Dukascopy's platform, you would add the normal market spread (let's say 2 pips just to keep things simple, it is lower than that during the London and NY sessions) to the bid price you want (1.19999), and place a sell "ASK ≤ Stop" order of that sum: 1.20019.
Opening a short position
So only if the ask price dropped to or below 1.20019 the order would have been triggered. This didn't happen because the ask price rose to 1.20275 during the volatile period, so you were no way near of having your order filled.
If the prices later dropped to 1.19999/1.20019 then your order would have been filled at 1.19999, short positions are always filled at the bid, irregardless of the order type you use.
● Long position
To open a long position (when the price reaches 1.20200, for example) the process is even simpler, because you don't need to include the spread. Simply place a buy "BID ≥ Stop" order of 1.20200 and your order would be filled at around 1.20220.
Opening a long position
As you can see it also would not have been triggered during the high volatility period. Note that long positions are always filled at the ask, irregardless of the order type you use.
► How to correctly place stop-loss orders
You are long EUR/CHF and want to close the position if the price drops below 1.20000, so you placed a normal stop-loss order at 1.19999. The market goes wild for a few seconds, the bid price reaches 1.19954 and you are stopped-out. Again, using the proper order type would have avoided this situation. To correctly place a stop-loss on a long position, you need to do exactly the same as if you wanted to open a new short position. Add the normal market spread to the bid price you want (1.19999), and place a sell "ASK ≤ Stop" order of that sum: 1.20019. You would not have been stopped-out.
If you are short and want to close your position if the prices gets to 1.20200 simply enter a buy "BID ≥ Stop" order of 1.20200, it would be filled close to 1.20220. This order would not have been triggered either.
"ASK ≤ Stop" orders are used to sell the specified pair in a dropping market. "BID ≥ Stop" orders are used to buy the specified pair in a rising market.
Short position with stop-loss Long position with stop-loss
Don't mix up the two and never use "BID ≤ Stop" or "ASK ≥ Stop" orders, or brokers which only offer those stop orders. There are only a handful of Forex brokers out there that offer the order types a serious trader needs.
Feel free to leave a comment or any questions you may have.