In this section, we will look into the sources of revenue that a forex broker makes in order to understand their motivation and behaviors behind their practices. Certainly, source(s) of revenue will impact on their bottom lines, which in turn affect you as their client.
As far as a forex trader is concerned, there are three basic practices of brokers in the market that we need to look at below:
- Market Maker or Dealing Desk Brokers
- STP (Straight Through Processing) Brokers
- ECN (Electronic Communication Network) Brokers
Figure 1 below depicts the above three basic practices of brokers and their relationships with clients and the interbank market.
(For the figure please visit my website for the complete version)
Market Maker Brokers: make money via spreads and trading against their clients (or sometimes called hedging against their clients).
All client orders are received and routed through their firms’ internal dealing desks. At this point, spreads are manipulated and provided back to clients with fixed different amounts for different currency pairs. Clients never see the real market quotes. For example, taking the EURUSD pair shown in the table below, what a client sees on their broker’s trading platform are quotes already manipulated, in this case ‘bid’ 1.3952 and ‘ask’ 1.3955. So the spread is 3 PIPs. The real market spread could just be 1 PIP. So the brokerpockets 2 PIPs.
When you buy, for example, EURUSD, your broker has to hedge against your order. That means the broker has to sell the same size of order for EURUSD. If you make money on this transaction the broker has to loose and vice versa. So your broker will do anything in their power to your disadvantage, otherwise they will be out of business. In reality, if your orders are small enough compared to the overall value of their book you might be under their radar. Some big dealing desk brokers out there are handling matters moreprofessionally, so there is still room for you to make money through this type of broker practices.
Having said above, it does not mean all traders avoid market maker brokers all together. The advantages of these brokers are that they require less fund to open an account (minimum 0 to a couple of hundreds dollars) and usually provide user-friendly trading platforms. This is useful when you just start out a trading career and probably do not have more than 5,000 USD for trading. The trick is that you should not be too successful with these brokers. Otherwise you will be under their radar and they will do anything intheir power to stop you biting into their revenues. There are several creative ways that you can be a profitable trader, protect your capital and profits, and under their radar all together.
In short, there is a conflict of interest between you and your broker. And there is nothing illegal about this practice. This is the game and most risks are resting with you: understanding the rules of the game and implement creative solutions to your benefits.
STP Brokers: make money via markups on spreads quoted from the interbank market, and not trading against their clients.
Client orders are received then marked up a few PIPs before being routed straight through to liquidity providers – banks and hedge funds. Banks trade with one another on the interbank market. A STP broker may have one or several liquidity providers. The more liquidity providers your broker has thebetter their client orders are filled.
So STP brokers help you access to the true market and no manipulations on prices against you. Their interest is to make you successful so that they can make money on markups from the spreads.
ECN Brokers: make money via commissions charged on a transaction, not on spreads and trading against their clients.
Client orders are received and internally bidding up and offering with banks, market markers and individual traders. In effect, all these participants trade against each other. Your broker does not trade against you.
By providing a marketplace above, these brokers charge commissions on your transactions. So their best interest is to make you trade as long as you can, so their commissions.
One of the key variables is the commission rate. You’ve got to shop around for the best rates and figure out if you your trading system has any chance of making money with these commission charges. Everyone has a different trading system that suits to his/her traits. Please refer to my other eBooks about this for details.
The drawbacks for most ECN brokers are that: their trading platforms are not user-friendly. You need to invest time to get used to them. If you trade the market long enough, this issue should not be a problem for you; they require higher minimum fund deposits, in range from 2,000 USD to 50,000 USD.
Today, there are ‘hybrid’ brokers who are both ECN and STP or sometimes called ECN+STP brokers. Both ECN and ECN+STP have basically no dealing desk.
YOUR TRADING STYLES
Knowing your trading style(s) is an indicator that you are serious about the trading business. You may have several trading styles implemented at the same time. Each style will require a different setup that should be supported by your broker(s).
Day trading style is that you open and close a trade within a market day. No open position is left overnight.
An open position could be left for seconds or minutes or hours but closing the same position should be completed by the end of the market day.
For this style of trading, you do not bother about overnight interest rates (called SWAPs or Carry Trade Interest Rates) credited or debited from your account. Detailed explanation will be provided in the CarryTrade sections below.
Scalping style is usually for traders who look for a few pip profits from movement of a currency pair taking place in a few seconds or even million seconds.
News trading is a special style that captures the usually gigantic movement of a currency pair when an economic news related to one of that currency pair is released.
This style of trading can be categorized as a day trading. However, due to the possibility of a gigantic move taking place in million seconds, finding an appropriate broker for this strategy is sometimes a difficult task. The reason is that your broker is not able to hedge your open position quickly enough, and therefore have to pay for your gain from their own money. So for this strategy, it is recommended to keep your position small enough to keep yourself under the radar. Otherwise, when detected they will do anything in their power to stop you playing this lucrative game for some traders.
Carry traders attempt to capture a POSITIVE interbank overnight interest rate difference between individual currencies in a currency pair.
For example, at this time of writing in October 2010, the interbank interest rates for AUD and USD are 4.5% and 0.25% per annum, respectively. So the difference is +4.25%. If you hold a BUY position for this currency pair AUD/USD overnight, your account should be credited with an interest rate payment calculated on a daily basis. In contrast, with the same currency pair, if you hold a SELL position rather than BUY overnight, your account is debited because the difference is NEGATIVE.
Note that credit and debit are not in the same rate because brokers internally calculate them after taking out ‘a piece of the pie’ for themselves! Even some brokers debit your account regardless of POSITIVE or NEGATIVE interest rate difference! I’d stumbled on this type of broker, so run for life if your strategy is to leave an open position overnight.
So thoroughly digging in details about their carry trade conditions if you want to use this strategy.
This trading style is where your positions are held for a few days. For this style, you would have many choices of brokers because slippage and delay are a less serious problem for you as would be with daytrading or scalping.
Pay attention to pros and cons of a fixed spread and variable spread brokers. Fixed spread brokers make you feel certainty about the spread cost at any time during a market day, even at news release moments. While variable spread costs could be lower at market stable times and more expensive at news releases. So knowing what timeframe during a market day you trade is crucial to selecting the most appropriate broker.
For this style of trading, you hold open positions for weeks or months. You should have no problems of various brokers to choose from. However, the most important thing that who are the liquidity providersto your broker.
When it comes to selecting a trading platform, every single trade has to decide one or more of the following criteria:
- Ease of use (look and feel of a platform)
- Execution of orders (one-click trading, off-the-chart trading, re-quotes, allowable distances for stops & limits, hedging, slippage)
- Security (secured data exchange over the Internet against hacking and theft)
- Platform stability and reliability (how regular the platform is disconnected)
- Order types (Stop loss, Limit Order, Buy Stop, Sell Stop, OCO)
- Mobile trading
Most brokers offer decent charting which is free while others charge a small monthly fee. Depending on your trading strategies and style, fee-based charting includes some advanced features. But free charts have sufficient features for a fair share of traders out there. I personally use free charting as part of my brokers’ platforms and still profitable because my trading strategies are simple and does not require advanced features.
Ease of use on a platform is another factor that some brokers out there strive to do for their clients in order to differentiate them the crowd. Some traders get used to MT4 platform interface, which is popular among traders and built from an independent vendor MetaQuotes Corporation. However, in my opinion, most platforms’ look and feel in the market today are good enough for most traders.
Fast execution of orders is crucial for day trading and scalping styles. For other styles it might not be that important. Some brokers set minimum distances (usually around 10 PIPs) from the current price for stops and limits. So be careful if they impact on your trading style.
Because trading online is basically exchanging data over the Internet, so security of data such as your personal information is of important. As a general rule, the larger and longer around a broker firm is the more money they spent so the better the security.
Order types are important and dependent on your trading style. Most platforms today offer market order, stop order (for stop-loss setting) and limit order (for profit taking setting), GTC (Good Till Cancel) and GFD (Good For Day). OCO (One Cancels the Other) is for advanced strategies and not offered by all brokers.
Mobile trading is increasing becoming a popular offer among brokers because it accommodates traders frequently on the move. At this point of writing, smart phones, iPhone and iPad are mobile devices that support forex mobile trading platforms. What you need to do is download Java based applicationsoftware and follow instructions from your broker’s website. Minimum bandwidth requirement of your mobile device is GPRS or 3G up.
Keep in mind that information presented on a mobile trading platform is just afraction of what you get on your desktop or laptop based platform. Most traders use mobile trading platform for monitoring trades or opportunities due to limitations of such devices such as small screen, internet accessspeed.
My recommendation is to download demo platforms offered by almost brokers’ websites and test them thoroughly. If you have any specific questions you can chat online with brokers to get answers straight away. Also be careful, some dishonest brokers give you the answers that are just to lure you open a live account with them. Another best solution is to consult with a trustworthy Introducing Broker (IB) to discuss and to get a clear understanding what you need. The IBs can help you best match your needs with various suitable platforms. By right, you should get free consultations from IBs because they are compensated by the broker firms that they are doing business with. So the key is to consult with reputable and trustworthyIBs only, in which their best interest is to add values to their clients on a long-term business relationship. As long as their clients are happy with recommended brokers so their compensated fees.
In short, it can be categorizes two basic platforms below:
Broker Specific Platform:
Most brokers offer their own trading platform, which could be a standalone application or a web-based or a mobile trading terminal.
Only large brokers have internal resources to develop the trading platforms themselves. Smaller brokers usually purchase licenses from software developing companies offering customized platforms for theirclients.
MetaTrader Platform (MT4 and MT5):
MT4 or recently MT5 under beta test is a broker-independent trading platform developed by MetaQuotes Software Corporation for forex, options and futures markets.
Forex brokers purchase licenses from MetaQuotes and customize their own versions. However, the back-end processing are still managed by MetaQuotes. The distinct features of MT4 are its support for a wide range of technical capability and enable traders to automate trading via programming language. In recent years, a new breed of automatic trading has been introduced and called Expert Advisors (EA) or simply ‘trading robots’.
The prevailing leverage for most forex brokers is 100:1. Some brokers outside U.S offer 200:1, 400:1 or even 500:1. But be careful, it seems that the higher leverages offered by brokers are to lure amateurs and gamblers in the market. And as a result, these people will lose money faster. Please see the section ‘Broker Practices’ above for further insights. The professional traders normally use leverage of 100:1 or even 50:1.
New ruling in U.S imposed a revised leverage of 50:1 from 100:1, effective on October 18, 2010, to all U.S. based forex brokers will certainly impact on traders who trade through U.S based brokers.
In my own experience, the leverage of 100: 1 should be enough for most successful traders to make consistent profits while keeping risks sufficiently low.
Today most small and large brokerage firms provide the following channels for customer support:
- Telephone call (fixed line, mobile and Skype)
- Online chat
However, again the larger firms the most likely that they have money to spent on fine-tuning their customer support process. It’s nothing more frustrating than if you need help, for example, about technical issues ordeposit or withdrawal of fund, there is no one there immediately to take your queries or give you answers. Some forex firms differentiate themselves by customer service quality.
One of the solutions is that you can consult with your trusted and experienced IB who has gone through the same problems. By this way, you can avoid lots of frustration and importantly your precious time. Your IB isworthwhile if they play a role of your first frontline consultant before contacting your broker. Again, your IB is compensated by your broker therefore they should provide you services free.
FOR FOREX MANAGERS
Successful forex traders are an elite group of the trading community. Remember that only 5% of traders are winners while the remaining 95% is losers no matter how time has passed and advances in technology.Some of the successful forex traders above move up to running their own forex funds. The greatest benefit of running such a fund is that you can leverage on money pool from investors who are busy with their work or passions with your trading expertise.
In this section, we’ll look into services provided by brokerage firms catered specifically for fund mangers.
Trading multiple accounts for your individual clients is probably an ideal proposition regarding your clients’ concern about misappropriation of their money in a traditional pooled fund. Bernard Madoff’s fraud case is a typical and biggest example in the financial market frauds history.
This type of managing your clients’ money offers many benefits as individual accounts are held under individual client names. Deposits or withdrawals are done through individual clients only. As a fund manager, you are not allowed to deposit or withdraw funds in their accounts. However, you are allowed totrade their accounts via a legal mechanism called Power of Attorney (POA). Most large forex brokers today offer this facility for institutional traders like you. Specifically, there are two type of modules for trading multiple accounts in the market today: Percentage Allocation Management Module (PAMM) andLot Allocation Management Module (LAMM).
PAMM enables a forex manager to distribute proportional profits/losses and fees among individual client accounts based on the whole portfolio structure. In effect, all accounts have the same percentage of returns regardless of account size.
LAMM allows the manager to allocate different trading lots to different client accounts. This mechanism essentially facilitates the implementation of different leverages on different client accounts, depending on the requirement or need of a particular client.
(Please visit my website at the end of this article for a pictorial explanation)
INTRODUCING BROKERS (IB)
Introducing broker (IB) is a client services arm to a forex brokerage firm. An IB drives clients to the brokerage firm that he or she has a relationship with; and provides value-added services to the clients for FREE. Well, it’s not actually FREE because the IB is compensated by his/her brokerage firm by a percentage of spreads on each trade made from clients for market maker brokers; or revenue sharing in the case of ECN brokers.
(Please visit my website at the end of this article for a pictorial explanation)
Many traders are reluctant to deal with IBs because they think that they have to go through middle men. This is not always true. There is a couple of good IBs out there providing many benefits to an individual trader that he or she cannot get if dealing with a brokerage firm directly. The section below explains why.
Value Added Services:
Most IBs provide value added services for FREE because they are compensated by their brokerage firm. The added services could be training, charting software, trading signal, so on.
Be careful with many dishonest IBs out there providing clients with “free” strategies or products that require frequent trades, and thus boosting IBs’ revenues.
Leverage of IB:
When you open a live account with any forex broker as an individual in the range of 1,000 USD – 10,000 USD, you are most likely put under the bottom line of their services such as higher spreads, customer support, etc.
In contrast, the same broker treats your IB as an aggregate client with, for example 20 clients with 5,000 USD-account each, a total account value of 100,000 USD. Well, this is a different story that your broker will do anything in his power to take care of the IB’s clients. Otherwise, your IB will take his/her clients away to somewhere else.
A few IBs offer rebates on trading costs (spreads) back to their clients. This is really beneficial to clients since clients’ trading costs are in effect reduced. But be careful, I had ever opened a live account through an IBs website with the promise of rebates that never comes! As usual, do as much due diligence as you can on a particular IB, specially web-based IBs if you have no chance to contact them face to face.
Managing your forex broker is one of essential risk management activities every successful trader does, and should be done early and thoroughly. As long as picking up a right forex broker is concerned, there are two options available to you right now:
Option 1: Go for regulated MM Brokers if your trading capital is less than 5,000 USD
Your trading capital is less than 5,000 USD and you intend to test the market. A market maker broker could be your choice at this stage. But remember that there always exists a conflict of interest between you andyour broker. This does not mean that you have to be a loser. You can be a winner provided that your trading style and strategies should be under their radar and winning big is not recommended!
As your circumstance changes, for example, you have accumulated more than 5,000 USD for trading capital, you can always switch to an ECN broker as described in option 2 below.
Option 2: Go for regulated ECN/STP Brokers if your trading capital is from 5,000 USD up ( ideally 10,000 USD up or equivalent)
If you have from 5,000 USD up to trade, it is recommended that you go for an ECN/STP broker. By doing business with an ECN/STP broker, it sets you free from the grey area of conflict of interest.
Some good ECN/STP brokers out there requires a minimum capital of 10,000 USD or even 50,000 USD.
Note that the above options mainly focus on initial trading capital amount, other factors should also be considered like below:
- Leverage level (50:1 / 100:1 / 200:1 / 400:1)
- Risk percentage of each trade on overall portfolio
- Trading style
- Country where a forex broker is domiciled for the tax implications
- So on
Experience luck everyday toward your fortune.