Forex Trading Course: Chapter 12: Forex Brokers & Your Due Diligence
The first thing to do before choosing a forex broker is to understand the terminology, the types of accounts which are available, and the way the broker will handle your orders. This article briefly explains these concepts.
1. Which Type of Account?
Most brokers offers a range of account sizes. The forex market is traded in fixedsized units known as lots but for retail traders these are subdivided to allow trading in smaller units.
The standard account trades multiples of standard lots. Where a standard lot is 100,000 units of currency. The smaller accounts trade in multiples of 10,000 units and 1,000 units respectively. The smaller accounts offer more control by allowing for “finer grained” trade management.
All brokers offer the standard account and a few will offer mini, and microaccounts. It’s wise to shop around though because spreads on the smaller accounts can be significantly higher than standard accounts. The number of markets you can trade will also be quite limited with the smaller accounts.
There’s also a fourth account that some brokers offer called a nano account. This trades lot sizes of 100 units.
Nowadays most standard accounts will allow you to trade in fractional lots at least down to the micro lot level.
Margin and Leverage
Most forex accounts "trade on margin." Margin is a form of borrowing and is whatprovides your leverage. For instance, if your account is in USD and offers leverage of 1:100, in a typical case you'll need to have at least $1,000 in your account to hold 1 standard lot worth $100k.
If leverage were 1:50 you would need a minimum margin of $2,000. The margin required for each instrument can vary.
Even if you have a relatively large amount of trading capital, it’s best to start trading micro or even a nano lots. Smaller position sizes give you far more flexibility. They allow you to build positions gradually without having to commit to trades with one big stake.
Many trading strategies require building positions incrementally. Likewise, most experienced forex traders realize that timing the market exactly is a futile aim.
Staggered trade entry is common in forex – and this is much easier if you’re able to trade fractional lots.
2. Managed or Self-trading Account?
Most people start out with a plain self-trading account. With this you can place trades and have full control over your funds.
There’s also what’s called a managed account. If you choose to open a “managed account”, you’re handing over control of your funds to an asset manager. Managed forex accounts are less common nowadays. Probably due to the increase in online trading and investment alternatives that are now available.
Managed accounts are better suited to those with substantial funds to invest – usually a minimum of $25,000.
The alternatives, PAMM and copy trading, which many brokers offer, are good choices if you want to risk a lower amount.
3. Market Maker or True Broker?
There aren’t any centralized exchanges in spot foreign currency trading, so retail brokers have different models for handling client trade orders.
Market maker They can “make the market” for their clients.
Straight through They can act as true brokers and simply pass orders straight-through to a dealer for execution – taking their cut along the way.
ECN They can allow clients to make their own market by trading with each other.
Straight through They can act as true brokers and simply pass orders straight-through to a dealer for execution – taking their cut along the way.
ECN They can allow clients to make their own market by trading with each other.
Some offer clients a choice of either market making or straight through execution.
In practice, due to the small trade sizes in retail FX, many brokers use “mixed model” order handling.
Though trading against clients is illegal it’s a theoretic possibility when your broker is also your market maker. Ideally, buyers and sellers are fairly evenly matched and the market maker offsets one position against another. They make a profit from the spread.
If there’s no offsetting client trade, the broker/dealer may be exposed to the otherside of a client’s open position – that is they become their counterparty.
If your broker is also your dealer/”market maker” you then have to rely on their credit worthiness and solvency. Broker/dealers who lack adequate capitalization can and do go bankrupt, taking their client’s funds with them.
Brokers who’re also market makers may offer lower average spreads than straight-through brokers (also known as “non dealing desk brokers”). They may also offer fixed spreads and guaranteed stop losses.
Beware though as in fast moving markets they can rarely fulfil these promises and may impede trading through various tactics such as requoting or freezing the trading platform.
Checking slippage should also be an essential part of the broker check. Slippage is the difference between the quote and the fill price. If prices are handled fairly the slippage should be random. If slippage is always against you it’s a sign of price manipulation.
The Market Maker’s Role
There’s nothing inherently wrong a broker who’s also your market maker. After all, this is the way corporates do business with the foreign exchange desks of the major banks. In a competitive market, the bank either has to price the deal competitively or risk losing the business, and potentially the client.
It’s up to the traders (price-takers) to decide if that price is fair or not. In this way the market participants arbitrage away any pricing inefficiencies.
Market makers quoting off-prices either go broke or are eventually forced, through losses, to quote “in line” with the broader market.
It’s always good practice to have quotes from at least two alternative sources. Even if you’re only actually trading on one account.
This way, you’ll soon notice any discrepancies in your broker’s pricing, as well as unusual spikes in volatility or spreads.
There are software packages around that will do this for you. Some packages will even go a step further and enter arbitrage trades where discrepancies are found.
4. Trade Copy
Check if your broker offers auto trading systems like : “copy trading”, PAAM, or signals. If you want to leave the market watching to someone else, and want a hands-off approach this is for you.
Services like copy trading, and PAAM are usually integrated within the broker websites.
If you want to use 3rd party forex signals, you’ll need to find a broker who allows these. Many do, but look out for restrictions on what type of signal (and strategies) you’re allowed to use.
If you’re a skilled trader but don’t have funds to invest, consider signing up as a PAMM manager where you can earn income from profitable trades.
5. Capital Protection
The banking crisis of 2007-8 has had a profound effect on people’s confidence in financial institutions. Check your broker’s policies on the following:
Negative balances What happens if your losses exceed your account funds? Some brokers will write-off the debt, while others won’t. Check if you’ll be liable to repay if your account goes overdrawn as a result of trading losses.
Protection of funds Make sure that your broker holds clients’ funds in a segregated bank account. If your broker becomes insolvent, the funds cannot then be used to repay the company’s debts.
Also be sure to read the fine print. For example, some brokers only offer segregation for larger accounts. Smaller accounts are “pooled” into the company’s working capital, and therefore are at risk.
Account domicile Verify in which bank your broker holds it’s client funds. Accounts in major banks within Germany or the U.K are preferable.
If the broker holds client funds in offshore jurisdictions like the Cayman Islands or Belize, be suspicious.
Always verify these facts yourself by telephoning the broker, through official email or if necessary by contacting their regulator. Never rely on information from third parties, including websites, they may be out-of-date or inaccurate.
6. Financial Regulation
Brokers operating in foreign jurisdictions are not always legally required to maintain licenses with regulatory bodies. In offshore locations governance is almost non-existent.
Reputable brokers will actively volunteer to be regulated in order to gain trust with their clients. Beware however because not all regulatory bodies are credible. Some of the offshore regulatory agencies are essentially nothing more than “rubber stamping” shops.
Many European forex brokers volunteer to regulate through agencies such as CySec (the Cyprus Securities and Exchange Commission). This body does at least impose checks and balances on things such as:
- Maintaining privacy of client data
- Know your customer compliance (for anti-money laundering)
- Maintaining auditable financial records
- Ensuring proper disclosure of risks
Having proper regulation also ensures that any complaints and breaches of financial rules are put out in the public domain. Always check the website of your broker’s regulatory organization for any non-compliance issues or complaints.
No hedging policies: Check if the broker has a no-hedging policy. Those under US regulations will have a FIFO (no hedging rule) that prevents you holding opposing trading positions in the same instrument at the same time and the order in which you can close out. It’s always worth checking this because certain strategies won’t work when this policy is in place or at the least they will need to be adapted.
7. Spreads
There are several means by which forex brokers make profits. Primarily it’s through spreads – this is the markup that’s applied on the bid/offer of every transaction you execute through their systems.
Spreads typically range from 0.2 pips up to 4 pips per trade for the majors. Spreads for exotic pairs can be substantially higher. If you’re using a mini account (1/10 sized lots), 1 pip is approximately $1.
Most brokers openly publicize this information on their websites. Always check the spreads of currency pairs you’ll be trading most often. Be careful because some brokers have highly competitive spreads for majors such as EURUSD and GBPUSD but this is offset by much worse spreads for other pairs – overall you may lose out.
Fixed or variable spreads? Non “dealing desk brokers”, will obtain their quotes from their liquidity providers – before adding their own markup. The liquidity providers in turn should be quoting rates in line with major broker-dealers on the Interbank network.
In the open market spreads fluctuate depending on volatility, liquidity and the competition between the professional Interbank participants.
Brokers can’t therefore guarantee fixed spreads – they’ll vary depending on which providers are quoting at any given time and the prevailing market. If you’re using fixed spreads, you’ll most likely have a higher percentage of “rejected trades”.
Brokers who’re also market makers sometimes offer fixed spreads. If your broker advertises fixed spreads, it’s almost certain they’re making the market for their clients.
8. Rollover Fees
One of the tasks performed by your broker is to “roll-over” your open positions – usually each night. The act of “rolling over” is simply done to move forward the value date so that you can trade without having to take delivery of the currency as would normally be the case.
If your trading strategy will likely involve holding positions for the long-haul (weeks or months), it’s extremely important to check the rollover fees your broker will be charging.
The settlement of interest payments occurs at rollover. You receive interest on the currency bought and pay interest on currency sold (unless the interest rates are negative in which case this is reversed).
There’s also an interest rate spread to pay which means you receive less interest on the bought currency and pay more on the sold currency.
Interest Rate Spreads
To get an idea of the interest rate spread your broker is applying do the following. Using a demo account, enter two opposing trades for the same currency pair and the same size. Choose a pair that has a high interest rate differential - e.g. AUD/JPY.
By convention in the market, Wednesday night is a "3-day swap" where interest is calculated to cover the weekend so be sure to check the days you do the calculation on.
Rollover fees are not usually significant unless you’re trading with high leverage and where the currency pairs have a large interest rate differential. With normal trading activity, rollover interest tends to cancel out and you just pay the interest rate spread (see the box).
It’s important to check your broker’s policy regarding rollover fees – this is where hidden fees and charges are often placed. Some add additional borrowing charges, increase spreads on high leverage accounts, or add interest markups for unrealized P/L.
In these situations rollover and weekend fees can quickly add up and reduce trading profits.
If you’re going to be carry trading (trading for interest profit), it’s important to select a broker to maximize your yield – there’s a huge difference between both rates and charges.
Some brokers don’t credit rollover interest at all. That is, both the long and short sides of the trade result in a charge. In this case, they may offer better trade spreads.
If you’re Islamic, you can open what’s called a “swap free” or Shariah account. This account doesn’t credit or debit interest to comply with Islamic law.
When opening a swap free account don’t forget to check for any eligibility conditions. Many people open swap free accounts to avoid interest. However what they don’t realize is that a markup is added instead to the spread – so overall it is unlikely to reduce trading fees.
9. Tools and Features
Broker platforms vary enormously in the amount and sophistication of tools they provide. At a bare minimum, the platform should provide a decent charting system supporting technical analysis functions and access to financial news and research.
Some provide their platforms over the web, mobile, MT4 connections and via smart phone apps. Others just provide web access and nothing else.
If you’re planning on becoming a full-time trader, you’ll most likely find 3rd party software such as MT4 or TradeStation the most suitable, while apps are handy for checking trades on the move.
10. Help and Support
Last but not least, you want to make sure your broker is there when you need to ask a question or have a problem. A good way to check the support system is to open a demo account, and try it out for yourself.
A reputable broker should have a dedicated support team that can answer your questions. In a live trading situation, phone or live chat is preferable to email where you may have to wait days for a reply.
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