All successful traders trade using a positive Risk/Reward ratio. There is no sense in having five 30 pip spread winning trades, and then one 200 pip spreads losing trade because at the end of the day you are 50 pips spreads down!
Some online forex brokers
now offer 3 to 5 pip spreads in the liquid currencies
such as EUR/USD and USD/JPY. These are very competitive prices which a few years ago were unthinkable. As recently as the mid 1990's brokers were quoting 10 pip spreads in the major currencies plus a commission!
The excellent value available from trading on tight spread works very much to the traders advantage. However, you should avoid overtrading and entering trades for just a 5-10 pip spread profit or loss. Even trading this way on 3 pip spreads can adversely affect your profitability.
Below are examples of both a winning trade and losing trade when trading for a 10 pip spread.
profit or loss:
Winning Trade:
Buy EUR/USD at 1.2020 (price = 17/20)
Sell EUR/USD at 1.2030 (price = 30/33)
Market moves 13 pips spread before taking profit
Losing Trade:
Buy EUR/USD at 1.2020 (price = 17/20)
Sell EUR/USD at 1.2010 (price = 10/13)
Market moves 7 pips spread before taking loss..
The above example highlights that the risk/reward of trading for a 10 pip spread profit or loss is poor.
For the same 10 pips spread, the market must move 13 pips spread for your winning position, but only 7 pips spread for your losing position.
As a general rule of thumb, we recommend that your Take-Profit or Stop-Loss levels are at least 10 times the pip spread you have traded on. This strategy will help avoid overtrading and improve risk/reward.
If you are a day trader or short term trader, in general we recommend not to "chase the market".
By this we mean you shouldn't for example buy Euro after it has already risen 100 pips spreads and is trading at the days highs. Or sell USD/JPY after it has come off 150 pips spreads and is trading near the days lows. The rationale behind this is that in many cases the market will consolidate and there will be better opportunities to enter into a new position.
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