Using the Bid/Offer Spread

At the core of how market makers trade is the way they use the bid/offer spread. Most
retail traders are taught to buy from the offer side of the market and sell to the bid
side. They are told that if they want to get trades executed then they will need to trade
in this way. After all, they are told, in futures markets the spread is only one tick so it
isn’t much to give away right? Wrong. In reality the bid/offer spread is far more
valuable than that as market makers have understood for decades.
In fact the business model for many if not most of the more profitable firms in this
industry is based around the profit available from the spread. Firms such as CFD
providers, FX platforms etc all use the spread as a key part of their profitability.
Meanwhile, of course, the large majority of their clients lose!
For the large majority of their trades, when they want to buy, market makers will join
the bid with a limit order. Likewise when they want to sell they will join the offer
with a limit order. They will not use market orders. This is what we must do too as
scalpers.
To understand why we should do this and to prove the power of the spread let’s look
at an example.
Let’s take a random spread of 15bid/16offer and look at all possible alternatives
within a 1 tick move of there. If we hold a trade for just a couple of seconds these are
all viable outcomes and I’m suggesting there is an equal probability of each one.
If we trade like retail traders and buy 16s (whether through a limit order to buy the
offer or a market order to buy), right now if we wanted to sell we could hit the 15bid
and lose a tick or work the 16offer and scratch.
If the market moves up 1 tick to 16b/17o, we could hit the 16 bid for a scratch or
work the 17 offer which would be a 1 tick profit (if filled which we will assume you
will be for this example).
If the market moves down to 14b/15o, we could work the 15offer which would be a
loss of 1 tick. Or we could hit the 14bid which would mean a loss of 2 ticks.
These are all the possible outcomes within 1 tick of our trade.
We can see there are 6 possibilities. Here, 2 are scratches, only 1 is a profit and 3 are
losses with one loss being 2 ticks.So, on any given price, if you buy the offer (or sell to the bid) you have just a 1 in 6
chance of profit with prices moving a spread each way. It might be worth repeating
that to yourself- you have just a 1 in 6 chance of winning!
This trade has a negative expectancy EVERY time you do it.
Obviously, traders will say that there system/indicator/pattern etc adds value and
means they have positive expectancy but most of the time this is BS. What I am
interested in, is the actual expectancy at this moment, of buying on the offer or hitting
the bid given each outcome has equal possibility (randomness).
Now let’s compare that to buying on the bid or selling only on the offer.
Back to our 15b/16o spread. Now if we buy 15s after joining the bid, right now we
could sell 15s which would be a scratch or we could sell 16s which would be a 1 tick
profit.
If the market goes down 1 tick to 14b/15o, we could work the 15offer which would
be a scratch or we could hit the 14bid and take a 1 tick loss.
If the market moves higher to 16b/17o, we could hit the 16bid for a 1 tick profit or we
could look to sell 17s which would be a 2 tick profit.
Again there are 6 scenarios but now the outcomes are very different.
Now, only 1 out of 6 is a loss. 5 out of 6 do not lose us money. 3 are profits with one
profit being a 2 tick profit.
Trading this way has a positive expectancy. Whereas buying on the offer produced
only a 1 in 6 chance of making money, buying on the bid produces only a 1 in 6
chance of losing. The contrast is stark and significant.
These are the numbers the industry don’t want you to know or think about. This is
why some FX and CFD platforms either won’t let you join bids or offers or if they
do, they won’t fill you unless the market moves completely against you (i.e. the bid
you joined has been traded through and now becomes the offer).
So the spread isn’t ’just a tick’ as most traders think. It is far more powerful than that.
It turns a trade from a 17% chance of winning to a 17% chance of losing. It turns a
trade from a negative expectancy to a positive expectancy.
That is why, those who understand this are loathe to give this edge up.
That is why so many firms exist who just make spreads and want people to trade on
them whether financial spreads, betting spreads etc. There is huge edge in making or
trading on the right side of the spread.Remember, I am talking about trading on a random spread, I’m not even adding any
edge of understanding value right now and which side of the spread offer better
opportunities.
But there is even more to this power of the spread!
Now ask yourself, ‘how many times a session does this spread exist?’ The answer of
course, is tens of thousands/hundreds of thousands.
This creates the next source of edge and profit – FREQUENCY. The spread might
just be 1 tick but to find it’s true value we should multiply by its frequency. How
many opportunities does it provide for us?
If we compare this to say a swing trade method. Let’s say your indicator suggests a
20 tick profit (for this example we’ll assume it is possible even though it is most
probably BS). How many times a day will you get these 20 tick set-ups with your
indicator? 1? 2? 3? If you multiply the profit potential by its frequency we can see
that the spread is more powerful than these trades.
Of course, though, the industry wants you to take the swing type trades while it takes
the spread trades! The industry wants you to take the low frequency, low probability
trade with high potential (potential being the word here not probable!) profit while it
does the complete opposite.
So for the vast majority of our trades we want to enter using the limit orders on the
spread. Exit trades will also usually be entered in this way particularly for slower
moving markets.
The exceptions for exit trades are usually for two reasons. First if a trade is going
particularly badly (moving fast against you) you may just have to get out with a
market order.
The second reason, is when a trade has gone very well in your favour and done this
quickly. Particularly, in faster moving markets, if you get 2,3,4 etc tick profits very
quickly then market orders on exit can still profitable and we can choose to take the
profit by trading at market (actually we want to use a limit order to hit the bid/lift the
offer). In addition, in faster markets these profits can disappear as quickly as they
came so taking profits is not a bad thing even if here we exit at market.
The question I often get asked when explaining that we enter with limit orders is, ‘but
don’t you miss trades by sitting on the bid/offer?’ The answer of course is ‘yes’.
Retail traders then usually tell me that this would be very frustrating and they would
prefer to sell to the bid/buy on the offer or chase the market to guarantee a fill. Theyare forgetting the whole point of using the spread – the expectancy and power of it. I
would usually rather miss a trade than hit the bid or lift the offer. The only time I
would trade on the wrong side of the spread is if I expect the move to be quiet large
(larger than usual). This could perhaps be after some news. Otherwise, knowing the
power of the spread, I am loathe not to use it for my trades as I know I am giving
away edge and reducing my chances of making money.
A huge part of the edge of scalping in this market makers style is the edge of using
the spread correctly.
When you know your edge you should rarely give it away. A huge part of trading is
discipline. If you don’t have the discipline to use the spread correctly, you will of
course fail to successfully implement this style of trading. Sometimes I do miss
trades, of course I do; so be it. There will be another trade soon enough (frequency).
Another upside of the frequency angle is this point; if I miss a trade there will be
another opportunity shortly. If a swing trader misses his trade, that may be it for the
day.
By using limit orders on the ‘right’ side of the spread I know that the vast majority of
the time I am ustilising the spread’s edge rather than trading on prediction.
Essentially when you lift the offer or hit the bid to open a trade you are predicting
movement. Why? Because the trade has to first clear the spread for you to make
money so there has to be some movement. Whereas, if, on a 15b/16o spread, I work a
15bid and get filled, I can place a 16offer and this would be a profit if filled. The
market hasn’t moved yet I can still profit; the sign of a trading style that doesn’t need
forecasting or market movement. I’ll refer more to this set-up later.

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