In this article, I will discuss Forex and CFD brokers. I will discuss how they operate and how to find one for successful trading. Many of the ideas that I share about these brokers will also apply to brokers of other securities like Bonds, Stocks, ETFs, and Options.
Table of Contents
- What to look for in a broker?
- Types of brokers
- Ways brokers can make money other than by charging fees
- Demo trading
I am a big proponent of building your own infrastructure. However, as a retail trader, there is only so much you can do. It is not cost-effective to pay for direct access to an exchange and co-locate some trading servers right there at the exchange. That is not what this article is about. This article is about building a trading infrastructure that is flexible and independent enough to be able to execute trades through any broker you see fit.
I believe that you should not get locked into a platform in a way that will allow you to only trade with the broker that provides the platform. That is why I use spreadsheets, open-source programming frameworks/libraries (python), and freely available charting software to do my trading analysis. But first, let’s go into what it is you should look (out) for in a broker.
What to look for in a broker?
When evaluating a broker ask yourself the following questions:
- Is the broker regulated? Avoid trading with brokers that are not regulated or are regulated in some sort of obscure jurisdiction. Try to go with a broker that is regulated in the UK (FCA), USA (NFA), or Australia (ASIC) as the regulators in these countries are most strict and offer the best protection against any possible funny business
- Is the broker trustworthy? Sure, this is a very general question, but there are some definite hints, that make me shy away from a broker. The biggest hint is when I am feeling sold to. If a broker is constantly calling and emailing me for my business or if they offer all kinds of promotions, then I do not trade with them.I mean, sure, a brokerage is a business like any other. It needs paying customers, but I feel that if the broker just stays out of my way and lets me get on with trading, it does me the biggest service of all. But if the broker mainly focuses on wheeling me in, then I get the feeling they are not out to let me trade successfully. A broker should build a long-term relationship with me, so he can keep earning fees for my trades. And I will of course only keep on trading if I am profitable. So this leads to the second question.
- Does the broker benefit from you profiting or losing? A good broker makes money off your losing trades as well as your winning trades. They just earn a fee in the form of a commission or spread. Some brokers take advantage of the fact that most retail traders lose money. They always take the other side of your trade. These brokers benefit when you lose. They are like a casino, where the house always wins. They will try and make you trade ever larger positions by offering you bonuses, competition, and extremely high leverage. My advice is to stay away from these kinds of brokers. These brokers are mostly revered as Market Makers, but that does not mean all Market Makers are bad.
- Where does the broker keep my money? Your funds must be held in a segregated bank account. This means that your money is not available to the broker for any other use than trading in your account. This will ensure that your broker cannot use your money to fund trades in his name. Because if these go bad the broker will run out of money and could end up not having enough money to refund your trading account balance when you request it. Some regulated brokers also have government guarantees for capital held for clients.
- What type of broker is it? It is important to know what business/trade execution model the broker uses, so you can understand the specific risks involved in trading with that broker.
|A broker makes money whether you win or lose, just like a Casino
Types of brokers
- ECN Broker
Electronic Communication Network BrokerThis kind of broker gives you access to an Electronic Communication Network or ECN. ECNs are virtual exchanges where buyers and sellers directly trade currencies with each other. So if you sell at a certain price someone else, not your broker, will take the other side of the trade and will buy from you. If you trade on an ECN you get access to the order book where you can see what offers are being made.
Fee structure: a usually small spread of the ECN and a commission from the broker that connects you.
Risk: You are trading a raw over-the-counter market. In extreme events like when the SNB removed the EURCHF plateau, you might not be able to find any buyers when you want to sell or vice versa. In this model your broker is not taking the other side of your trades, nor does he have to.
- STP Broker
Straight Through Processing BrokerAn STP Broker will automatically route your orders to multiple exchanges, like ECNs, Interbank exchanges, in-house exchanges, and other liquidity providers.
You will pay a fixed or floating spread. The idea is that as everything is automated the broker continuously hedges the risks of clients’ positions. This way the broker has no other interest, than making money off the difference in ask and bid price, or spread. This is a model that is also used by many stocks and options brokers and is usually referred to as smart routing. The difference here is that you will also pay additional fees unlike with Forex and CFD Brokers where the fee structure is usually just the spread.
Fee structure: Spread (and for stocks and options brokers additional fees)
Risk: With an STP Broker you do not get access to the order book, so you cannot check to see if your order was properly matched with an order from someone else. You just have to trust your broker. So the risk here is a poor quality of execution and opportunity risk. For instance, on an ECN you might have been able to execute a trade at a certain price, but with your STP Broker, your trade was not triggered. To mitigate this it is important to periodically review the trade execution of your broker and if it falls short, move to another broker.
- MM Broker
Market Maker BrokerA pure Market Maker Broker is a broker that literally makes a market between you and other clients and some liquidity providers. Sure enough, most transactions are automated, but market maker brokers will give re-quotes or fail to execute trades. At MM Brokers there is a dealing desk that monitors the (aggregated) positions of (all) clients (combined). This dealing desk will be able to interfere with the trade execution the way they see fit. This can be a good thing as well as a bad thing. With this type of broker, you can trade whenever the broker allows you to. Some brokers also allow you to trade when markets are closed.
Fee structure: Spread
Risk: Same as with the STP Broker, but besides, there is the possibility that the dealing desk of the broker will interfere with the trade execution in a way that might harm your trades.
|Marking a market
Ways brokers can make money other than by charging fees
Brokers charge fees in exchange for giving you access to tradeable markets. This is one way they make money.
A broker makes money whether you win or lose.
Broker fees can vary quite a bit. Some very cheap brokers offer execution-only and more expensive ones that offer more services like managed accounts, over-the-phone trading (actually speaking to someone), etc.
But trading fees are not the only ways brokers make money. I think it is good to know about this. Just realize that if you can trade extremely cheaply, it might mean that the broker will most likely make more money elsewhere. It is like when something is offered to you for free, then you just might be the product…
Here is a list of a few ways brokers can make money besides trading fees.
- Additional services
Some brokers offer additional services like hosting of trading software.
- Prop trading
Brokers can have a proprietary trading desk that trades with the broker’s own money. This desk can look at aggregated data of all the broker’s clients to make their trading decisions.
- Front running/arbitraging
As brokers can see your orders coming, they could (and will) front-run your orders. For example, the broker sees many buy orders at 10 USD. If they can buy the security cheaper from some other exchange, they can then sell it immediately for a small profit without any risk.
- Taking the other side
Many MM and STP brokers classify their clients into 2 buckets of traders:
1 Consistently Profitable Traders
2 Losing Traders
What they will do is, they will hedge all the trades of the profitable traders and take the other side of the trades made by the losing traders.
- Stop hunting
Stop hunting is when the price is pushed passed your stop order to hit your stop loss before turning around and moving in the direction of the trade you just got out of with a loss. Maybe some brokers will manipulate the price on their trading platform to hit a group of orders. However, I think that most stop-hunting is done by big players in the market that will sometimes push prices passed certain levels of which they know many traders have orders placed. And then they will move the price in the opposite direction. This is simply one way big players take money from inexperienced retail traders.
I say, first, look at your stop placement before you start blaming your broker.
Almost all brokers offer some sort of demo account, that allows you to paper trade. Some even offer non-expiring demo accounts.
One of the biggest mistakes I made is, I demo traded for too long. Demo trading is useful to get to know the technicalities of a trading platform and to learn and test a new trading strategy. But if you really want to learn how to trade, you need to trade with real money.
In Forex you can trade with a small account. You can just take it slow and still experience the emotions of trading with real money. From there on you can slowly grow your positions by adding more funds to your account.
So, in conclusion, I would like to say: Stay flexible. Set up your trading process in a way that you can execute on many different brokers. Do not rely on broker-specific tools. In the next article, I will go into the tools you can use to trade.