The traditional definition of a forex broker is one who puts buyers and sellers together for a commission or fee. Many forex brokers make their money by charging you a spread, the difference between the buying and selling prices for a currency pair.Spreads greatly impact your forex returns and vary depending on the type of account you open. As buying low and transacting high is the trader’s goal, a wider spread means you have to pay more when you buy and wind up with less when you sell. In some cases, your broker gets the difference, which is added onto the price of the trade. Spreads often narrow or widen depending on market liquidity and other factors.
Pips (Percentage in Points) are the smallest price unit of a forex currency, which is quoted to the fourth decimal point. Spreads, one of the primary costs of your forex trading, are measured in pips and the slightest variances can make a big difference.
I have worked with many different types of forex brokers and have witnessed the haphazard ways in which clients’ investments were distributed. In many cases, the trading transaction would go into a ‘bucket’, and never actually execute. My heart would go out to the scores of clients who had quit their day jobs, anticipating income from trading forex, only to learn their profits had disappeared due to some alleged violation. In reality, there was no profit to deliver since the buy/sell trade never happened and the broker had to come up with an excuse. These types of brokers operate in what’s commonly known in the forex industry as a “bucket shop.”
From Electronic Communication Networks (ECNs) to retail forex companies, the type of forex broker chosen is a factor in the timeliness and return on your investment. ECNs do not trade against you and act as an Interbank broker in the free market by connecting the major banks and brokerages with individual forex traders. The spreads may be smaller but you know upfront what you’re paying for the service – either a flat fee or commission.
Retail forex companies are glorified bucket shops and are often referred to as market makers, since they essentially create their own trading markets. Spreads are arbitrarily decided, trades are made against you, and profits are distributed at the broker’s discretion. Retail forex companies are attractive to newcomers and those short on cash because they don’t require large investments. If you don’t mind running the risk of having your profits disappear on a whim, then retail forex companies are a good place to learn the ins and outs of forex trading. They allow you to demo trade on their platforms until you know what you’re doing and give you unusually high leverage.
Of the two types of brokers, a forex ECN broker is the more legitimate. They provide a place where banks, traders, and multiple market makers can enter competing bids and offers around the spread amount. Unlike a dealing desk, bank quotes are consolidated and orders are matched to the best bid/offer price on which traders are permitted to trade. Although minimum trade requirements are often higher and leverage is lower, prices are not manipulated, profits can be more stable, and trades are passed to a real trader, the Interbank.
When honestly executed, forex spreads can be a valid indicator of what’s happening with your trade. After years of mistakes and believing everything I was told, I now know to look for the red flags, such as reverse pips, rejected transactions, tight spreads, and delayed executions. These are common strategies used to deceive many forex traders.
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