How Forex Brokers Make Money
Forex trading is immensely popular with online access enabling people to trade from anywhere in the world and make a substantial amount of money from a very small account. The foreign exchange market works whereby traders buy and sell different currencies based on whether they think the currency will increase or decrease in value. It is a high-risk business and sees over $5 trillion dollars traded each day.
In order to execute a transaction, traders have to go through an intermediary known as a broker. Irrespective of the profits or losses experienced by individual traders, brokers have to make money and they do this by charging commissions and fees, some of which are hidden. It is very important to understand how brokers are compensated as it can help a trader choose the best broker for their needs. In this article, we look at how Forex brokers, including ECN brokers and binary options brokers operate and the differences in the ways in which they make money.
Forex brokers work by taking orders to buy or sell currencies and executing them. In return for executing these buy or sell orders, a forex broker charges a commission per trade or a spread, and is the way in which they make their money. A spread is the difference between the bid price and the ask price for the trade. The bid price is the price a trader receives for selling a currency, while the ask price is the price they have to pay for buying a currency. The difference between them is the broker’s spread.
Brokers can also charge both a commission and a spread on a trade while some even claim to offer commission-free trades. In reality, these brokers usually make a commission by widening the spread on trades. Spreads can either be fixed or variable. With variable spreads, the spread will vary depending on how the market moves. A major market-moving event, such as an increase in interest rates could cause the spread to change. This may be either favorable or unfavorable to a trader. If the market gets volatile, a trader could end up paying much more than expected.
Another aspect to note is that a forex broker could have a different spread for buying a currency and for selling the same currency. Hence, a trader needs to pay close attention to pricing and be aware that there are several different kinds of brokers including market makers, STP and ECN brokers who all have their own commission or fee structures. Brokers who are well capitalized and work with a number of large foreign exchange dealers to get competitive quotes typically offer competitive pricing.
ECN brokers use an electronic communications network to put their clients directly in touch with other currency traders. They do this by linking the buyers and sellers to an automatic program which matches markets orders and then executes them.
As ECN spreads are much narrower than those used by everyday brokers, ECN brokers are compensated by charging their clients a commission per transaction on behalf of the traders.
When a trader has chosen his currency pair, an ECN broker provides them with an order book comprising ‘bid prices’ of buy orders, the total volume of the bid price, the ‘ask price’ of sell orders and the total volume of the ask price. All quotes come from the market participants and the ECN matches the best ones to each other and then displays them directly to the client.
As the service provided to clients by an ECN broker is simply to match trades between market participants, it cannot trade against the client and is thus compensated by imposing commission fees for each client’s transactions. The higher trading volume the broker’s clients generate, the higher the broker’s profitability. ECN brokers typically offer their clients competitive spreads as they are able to engage in sharing information with other brokers to establish the right price.
Binary Options Brokers
Binary options trading is another increasingly popular form of investment in the financial markets. Unlike the forex market where the brokers charge spreads or commissions, binary options brokers operate in a different way and actually make money through a variety of methods. One way is through the pricing of the binary options while the other is through the trading activities of their clients.
Binary options brokers usually obtain their pricing structures from their liquidity providers, however, some traders may not be aware that the pricing of the binary options that they are trading is actually marked up slightly from those in the market. Binary options traders tend to check out the prices of the asset displayed on the broker’s trading platform together with the expected payout, but those who scrutinise this more carefully will find that the expected payout is not calculated based on a true percentage payout. A certain percentage of the payout is actually retained by the broker and this constitutes the commission that the binary options broker is earning.
Another way in which binary options brokers make money is through the trading activities of their clients and cashing in on the money placed on losing trades. If a trader places a bid and predicts it correctly, they will receive their money back plus an extra 80% (not 100%).
On the other hand, if a trader places a bid and predicts it wrongly, they lose all their money invested in that trade. All this money goes to the broker, although in some cases, brokers will give the trader a small percentage back. Hence, brokers are compensated by pocketing the difference between the percentage that losers will lose and the percentage that winners will make.
As we have seen, brokers tend to charge on a commission or fee basis, but binary options brokers operate a different business model. It is, therefore, a good idea for traders looking to invest in the forex market to find out how their broker of choice makes money since their charges will inevitably affect their bottom line.
It is not only advisable to check a broker’s payment structure, but also their terms and conditions before proceeding in order to steer clear from those offering fraudulent get-rich quick schemes promising great returns. Each broker has its own quoting method and it is ultimately up to those who are undertaking transactions in the forex market to ensure that they are getting the best deal available.