The foreign exchange market, or Forex, is the largest exchange market in the world (Lien, 2014) with an average daily volume in the trillions. The forex market is the largest and most liquid financial market in the world, with an average of $2,000 billion traded daily . Rather than having a central market, such as the NYSE where a record of every transaction is kept, forex trading occurs as over-the-counter (OTC) between individual traders. Banks are the primary market makers and have relationships with other banks and online retail brokers . Each organization’s relationship is individually valued based on their capital and creditworthiness. The Forex market is open for 24 hours a day, five and a half days per week , allowing currencies to be traded almost continuously.
Forex brokers make the market accessible for investors who are new to the market. Brokers are able to offer investment strategies, excellent trading platforms or online education opportunities for investors. The relationship between investor and broker is a simple one. The client, or trader, pays the seller, or broker, a fee (a fixed commission or bid/ask spread on the traded asset) to access the Forex market . The broker’s job is to make their client money. New investors in the Forex market often need the expertise of a Forex broker to encourage them to make trades that they might otherwise deem as too risky. The more money the investor makes, the more money the broker makes. Investors must take a hard look at the commission structure of the broker to ensure that they are not paying for advertising, a middle man or other items that benefit larger investors and penalize the smaller investor.
As with the NYSE, individual investors, investment brokers and financial institutions are free to trade on Forex. Like trading stocks, investors need to be well versed in platforms, regulations and financial regulations regarding Forex trading. Many investors choosing to enter the Forex market do so with the help of a Forex broker. Prudent investors do a considerable amount of research prior to signing an investment contract with a Forex broker. Brokers who work for financial institutions with large trade volumes and have strong financials receive access to superior prices and provide better execution of transactions. Brokers who have ties to ten banks’ price quotes is able to pass an average bid and ask price offering a more competitive spread to investors than a broker who only has ties to five. It would be wise to investigate which banks the broker has ties to, in that some banks are more competitive in the Forex market than others.
Every Forex broker has different types of accounts that vary in deposit amounts, lot size, how commission is paid, leverage, rollover interest policy which affect the risk level of every investment. Investors must search for a broker that has the ability to meet their risk level while maximizing their investment. It is recommended to compare the best forex brokers on the market, before you open a real money account with them.
Before working with a broker, Forex investors should investigate brokers by reading posts regarding other investors’ and traders’ experiences with the broker. The sole job of a Forex broker is to bring the investor into the Forex market and act as the liaison between the Forex market and the investor’s money. As with any business, there are good brokers and bad brokers. The trick is to learn how to ferret out the bad ones. Every good Forex trader shares similar traits.
They encourage open communication in every step of the process. Every investor has their own level of comfort with communication. Some investors want to be constant communication with their broker, while others are comfortable with conversations that occur on a weekly or monthly basis or when there is a major change in position. The broker should have experience in the Forex market. This should go without saying, but too many investors decide to sign up with a friend of a friend because they are new to the business. The broker’s job is to make money for both the investor and themselves.
Good Forex brokers execute transactions on time, hold an investor’s trading capital, provide an investor with a good trading platform with real-time pricing and will train the investor to use the platform. The broker should also provide their own analysis and provide guidance on Forex trading
The choice of a Forex broker is intensely personal since the investor is entrusting a piece of their financial future in an OTC market that is not a tightly regulated as other financial markets. Research is key to finding the best Forex broker.
Is the Broker Regulated?
In the United States, reputable brokers are members of the National Futures Association (NFA) and are registered with the U.S. Commodity Futures Trading Commission (CFTC) as a Futures Commission Merchant and Retail Foreign Exchange Dealer. The NFA is a self-regulatory group for the futures market in US and develops the protocols and programs to help members meet all regulatory responsibilities for foreign currency trading. The CFTC is an independent agency that regulates the futures and commodity markets in the US. The CFTC also lists the capital available for all its members on its website and updates it monthly. US regulations require that investment firms in the Forex market must have a minimum of $20 million in capital to operate within the US.
When meeting with a broker, ask to see their membership number for NFA and their CFTC membership. Brokers’ websites should clearly state their NFA number and their membership in CFTC. While it is possible to trade in the US without membership in the NFA and CFTC, brokers with membership in these entities have meet the standards set forth by both agencies and are held to a high standard. This is particularly important since brokers are not required to keep investors’ funds separate from the firm’s operating capital.
In the United Kingdom, there are no restrictions placed on where currencies can be traded online. The Financial Conduct Authority (FCA) is the regulatory agency for Forex trading in the UK. Since London is a major Forex trading center, many brokers are FCA licensed and offer GBP trading accounts as well as several banking offers that appeal to UK Forex investors.
Australia is loosely regulated, despite Sydney being a major financial trading city for Forex. The Australian Securities and Investments Commission (ASIC) offers licensure and regulation for brokers who wish to comply with their regulations.
Canadian investors can freely trade in Forex without strict regulations and few restrictions. The Investment Industry Regulatory Organisation of Canada (IIROC) does have the authority to enforce all regulations and laws imposed upon Canadian traders by Parliament.
European traders have virtually no restrictions regarding their access to online Forex trading. The EU is, however, one of the most highly regulated areas for Forex trading. Nearly every broker offers trading accounts with both EUR and GBP accounts and has the option to make deposits in euros, pounds or the dollar.
What Type of Accounts Does the Broker Offer?
Each broker generally offers four types of accounts.
- Leverage is a loan that is offered to margin account holders by their brokers and is expressed as a ratio between total capital available to an investor to the actual capital in an investors account. As an example, a broker can offer a client with a $1,000 account a position valued at $50,000 using a 50:1 leverage. Leverage is an advantage for traders with winning positions since it allows investors to maximize their profits. Conversely, a trader can lose their entire portfolio since leverage works the same way with losses. Investors with limited capital should consider using a broker that offers high leverage . Investors with capital can work with a broker who utilizes a variety of leverage options. Brokers should explain leverage completely prior to establishing an investor’s account.
- Most Forex accounts have a minimal initial deposit, often as low as $50. However, most accounts require a $250 minimum deposit. These low initial deposits make leverage accounts appealing to new investors. These small accounts are often referred to as mini accounts. A standard account allows investors to trade at various leverages and requires a minimum initial deposit of $2,000. Premium accounts are those which hold significant amounts of capital and allow various levels of leverage and often offer concierge type services to investors.
- Most brokers have their own requirements for deposits and withdrawals. Accounts funding can be done by wire transfer, personal or business check, bank check, PayPal or online by credit card or ACH payment. Withdrawals are generally made by wire transfer or check. Brokers can charge a fee for deposits, withdrawals or both.
- Brokers are paid through commissions paid on accounts and their spreads. Brokers using commissions can charge a fixed percentage of the spread. There are brokers that charge no commissions and make their money by utilizing wider spreads between the bid and ask price of forex pairs . The wider the spread, the harder it is for the investor to make a profit. The more popular Forex pairs, EUR/USD and GBP/USD, generally have a tighter spread than those currencies traded less frequently.
What Types of Currency Pairs are Offered?
Despite the wide variety of currencies available for trade in the Forex market, there are certain currencies that undergo the majority of the trading.
- US Dollar/Japanese Yen (USD/JPY)
- The Euro/US Dollar (EUR/USD)
- US Dollar/Swiss Franc (USD/CHF)
- British Pound/US Dollar (GBP/USD)
While brokers may offer any combination of forex pairs, most brokers offer these four since they are the most popular. Brokers can also offer trades in gold, silver or oil.
What Type of Customer Service is Offered?
Since trading occurs around the clock, the broker’s customer service team should be available around the clock as well. Account holders should be able to talk to a live person, rather than an automated attendant. Use the initial phone call to gauge the broker’s commitment to customer service. Wait times should be minimal and calls should be returned promptly. Brokers should be able to provide complete answers in easily understood terms.
Many investors are comfortable using the internet for customer support. Investigating email turnaround time and live chat support with questions gives investors a good idea of how valued their business is.
It is the broker’s job to communicate with their investors at every step of the investment process. They should communicate that orders are being executed per their investor’s orders as well as in times when the market is undergoing negative changes that can drastically affect a client’s account. The broker must know the fundamentals of Forex investing and it is their responsibility to ensure they educate their clients on the finer points of Forex investing.
Prior to signing with a broker, utilize each type of customer service. Asking questions, particularly if the answer is already known, is a good way to judge not only the knowledge of the customer service staff, but also their level of patience. Brokers should be able to provide information on spreads, leverage, regulations, and deposit and withdrawal procedures. They should also explain the financial stability of the investment firm and balance sheets to show solvency. The broker’s length of time in the business and their trade volume should also be disclosed. Ask how the orders are executed; manually or electronically?
What is the minimum trade size?
Finally, ask about any consumer protection policies the broker has in place. Do they carry error and omissions coverage? Is there coverage in place in the event the brokerage is charged with fraud or bankruptcy?
What is the Trading Platform Like?
The trading platform is the software investors use to manage their account. Investors monitor their accounts and should receive real-time updates throughout their session. A good trading platform offers ease of use and is visually pleasing . Often the difference between a good Forex broker and a great one is their trading platform.
- Technical and analysis tools should be readily available and easy to access. Analysis should come from more than one source and should be current. Real-time charts and news should be included.
- Trades should be simple to enter and exit.
- Buy and sell “buttons” should be clearly marked. Upon requesting a buy or sell, the platform should confirm the investor’s intention. Some trading platforms offer a “panic button” that allows investors to close all their open positions .
- Some investors want to customize their investment home page, allowing them to have specific data available upon logging into their account.
- Taking advantage of the investment firm’s demo account allows investors to utilize the various functions of the trading platform, except for executing an actual order. This allows potential investors to check integration and security features without actually investing funds. One caveat: The only item that cannot be verified in demo mode is the speed of deposits and withdrawals from the account. While this should be addressed when discussing customer support, there is no way to verify this until the account goes live. However, the demo account should give potential investors a visual image of how smoothly each type of transaction occurs.
The most popular trading platform among both brokerage firms and individual investors is the MetaTrader 4 (MT4) platform. The MT4 platform compiles the hundreds of free indicators that are available on the web and allows users to import trading robots . Because it is free, the majority of brokers use this platform. MT4 is popular in the US, while ACT Forex is the most commonly used platform in Europe. ACT Forex looks and acts very similar to MT4.
Who Executes the Broker’s Orders
There are two ways Forex brokers can execute their orders.
- If the broker uses the Dealing Desk, or market maker, method, they are responsible for creating the pricing and executing the orders. In this method , the broker takes the trade, then tries to find a match for the order with another investor. The spread is generally fixed and are higher than the average variable spreads. For example, if there is 2 pip spread in the US/JPY market, but the broker only offers it as a 4 pip spread, the broker is taking the 2 pip difference has commission. These brokers make their money by buying at a lower price and selling at a higher price, which allows the broker to earn money on both ends of the transaction. Brokers using the dealing desk method generally do not charge any other fees. Orders placed with a dealing desk broker rarely leave the broker’s own liquidity pool, thus never reaching the interbank market. This can be a positive since the orders become self-sustainable . Many brokers place restrictions on orders during economic news or events since this is an essential time to trade. Dealing desk brokers generally offer fixed spreads as commission.
- If the broker does not use a Dealing Desk, then they are a true broker, allowing investors access to the interbank marketplace. The broker uses the Electronic Communications Network, or ECN, to match an investor’s trade with others traders electronically. This allows the broker to look at the streaming prices of several banks, which are competing for the broker’s investment dollars. As an example, an investor wants to bid a EUR/USD at 1.4056 and there is no match, the investor’s order goes unfilled . The ECN charges for each trade, which is their commission. This eliminates any increase in the spread as broker compensation. Generally, the spreads are tighter, but there are transaction fees involved. These types of orders are executed by the banks, not the broker, alleviating trade restrictions due to economic news or events. Some brokers use straight through processing. In this type of brokerage, every investor’s order is completed electronically and instantly forwarded without any broker intervention. The order is processed on the interbank market.
Is There a Minimum Deal Size?
For smaller investors, minimum deal sizes can be an issue. Some brokers only permit trades in standard lots. A standard lot is 100,000. An investor with a $5,000 account value does not have much investment flexibility in terms of money management. As a general rule, the better the “resolution” an investor has when calculating a deal size, the more accurate the money management calculations will be. Investors with small account balances should look for brokers that offer investors deal sizes as small as a single unit to provide investors with the greatest flexibility for choosing the size of their trades and positions . Take note of the spread for small transactions. Often brokers use smaller deals to improve the spread for large account holders.
A pip is the smallest price change any particular exchange rate can make and are generally priced out to four decimal points . The smallest change for the majority of exchange rates is 1/100th of one percent increase or decrease. In Forex trading, profits and losses are determined by calculating the number of pips gained or lost. Most Forex brokers round prices up or down to the nearest pip. There are now some brokers that offer Fractional Pip-Pricing. Fractional Pip-Pricing adds and additional decimal place to the pip, creating spreads that are more accurate.
The spread broker’s offer is calculated in pips. Since Forex brokers generally do not charge a commission, the spread, or difference in the purchase price and selling price, is how brokers make their money. The difference in spreads varies just as the difference in commissions charged by investment brokers. The lower the spread, the less money the broker makes. The tighter the spread is, the higher the chance of market volatility. Be aware that low spreads are generally offered only to investors with large accounts. Investors with micro and mini accounts are generally not afforded a tight spread.
Good brokers publish their spreads or will provide you with documentation when asked. Prior to signing, research the typical spreads for the common currency pairs (EUR/USD, for example) as well as any more unusual currency pairs that pique the investor’s interest. Many brokers offer low spreads only on common currencies and investors lose money on the less common currency pairs.
Margin accounts allow investors to borrow to increase their potential return on investment. Forex investors use margin accounts when they want to invest by using the leverage of money they borrow to control a larger position, creating a larger return . Margin accounts are managed by the broker and are settled each day in cash. These accounts are simply short term loans made by the broker to the investor. The margin is the leverage the investor accepts.
Prior to placing a trade with their Forex broker, the investor must deposit funds into a margin account with the broker. This amount is individually agreed upon between each individual investor and their broker. Investors trading in $100,000 currency units or more generally have a margin percentage of 1 – 2 percent. This allows them to open a margin account with $1,000 – $2,000. The remaining amount is provided by the broker.
Interest is not directly paid on margins. However, if an investor fails to close their position before the delivery date, the account is rolled over. Interest can be charged, depending on the whether the investor’s position was long or short and what the short-term interest rates of the underlying currencies were at close.
Investors trading with “borrowed” or leveraged funds must accept the level of risk the broker is willing to take, rather than the level of risk they are comfortable with. This allows the broker to buy or sell at their discretion. This poses a problem for investors with smaller cash accounts. In the event the position an investor holds sharply drops, the broker has the right to liquidate the position on a margin call even if there is enough cash to cover the loss in the investor’s account.
What Type of Analysis?
There are two basic types of strategies in Forex investing; technical analysis and fundamental analysis.
- Fundamental analysis in Forex values the entire country. It is extremely complex and is generally used to predict long term trends. There are several currency indicators used in fundamental analysis such as non-farm payrolls, Purchasing Managers Index (PMI), the Consumer Price Index (CPI), retail sales and durable goods . Fundamental analysts also review economic meetings involving interest rates, inflation and any other issue that can affect the value of a country’s currency. If a broker uses a fundamental analysis strategy, their platform should provide real-time access to the release of these reports.
- Technical analysis involves analyzing price trends in currency markets. Forex technical analysis must consider the around the clock nature of the markets when analyzing data. The most common forms of analysis are the Elliott Waves, Fibonacci Studies, Parabolic SAR and pivot points . Some analysts combine these reports to create a more accurate picture. The most common combination is the Fibonacci Studies and Elliot Waves, while others track trades to locate comparable buying and selling situations.
Rollover is interest that is earned or paid on a Forex position that is held overnight . The rollover amount is dependent upon the difference in the interest rates between the currency pairs and varies daily with the movement of the prices of the currencies. A Negative Roll occurs when an investor sells a currency that is paying a higher rate of interest. The investor is responsible for paying the difference in the interested.
By contrast, a Positive Roll occurs when an investor purchases a currency that pays a higher interest rate, allowing the investor to collect the interest. Nearly all brokers charge the Negative Roll, but not all brokers offer Positive Rolls.
One Forex strategy known as the “Carry Trade” is a benefit of the Positive Roll and high leverage amounts. For instance, if an investor purchases the USD/JPY, they can earn a positive roll. The investor is simply borrowing the Yen at a low interest rate to buy the Dollar at a high interest rate .
Is Hedging Available?
Hedging allows investors to hold both buy and sell positions in the same currency pair at the same time. Hedging is not insurance against risk since it is possible to be on the low side of both positions. If the brokerage does allow for hedging, a stop-loss order should be placed on all hedged positions to moderate the risk . Spot contracts and foreign currency options are the foremost methods of hedging currency trades.
Spot contracts are the typical trade made by a Forex investor. They have a short-term delivery date of two business days so they are not effective for hedging purchases.
Foreign currency options are the most popular method for currency hedging. The foreign currency option gives the purchaser the right, but not the obligation, to buy or sell a currency pair at a particular exchange rate at some point in the future .
Hedging strategies generally have four parts.
- A risk analysis is done to identify the type of risk the investor is taking in the current or proposed positions. Then the broker identifies the repercussions of taking the risk without hedging and looks at the level of risk in the current Forex market.
- The broker then looks at the risk tolerance of the investor to determine how much of the position should be hedged. Risk tolerance should also include how much the investor is willing to pay to eliminate the additional risk.
- If foreign currency options are used, the broker must decide which Forex hedging strategy is most effective for this investment.
- Once the strategy is implemented, the strategy must be monitored to ensure risk remains minimal.
Does the Broker use the Spot Market or the Forwards and Futures Market?
When speaking about the Forex market, most investment professionals are referring to the spot market. The spot market has always been the largest Forex market. It is the “’underlying’ real asset” on which the forwards and futures market is based . The forwards and futures market is popular with large investment companies that need to hedge their risk out to a future date.
The spot market buys and sells currencies at current price, which is determined by simple supply and demand principles. When the transaction is final, it is known as a “spot deal.” In the spot deal, both parties receive their desired currency amount at the mutually agreed upon exchange rate. Once the position has closed, a cash settlement is paid in two business days.
The forwards and futures markets do not actually trade currencies. Instead, contracts representing claims on a particular type of currency for a particular price are written with a future date for settlement. In the forwards type of contracts, the parties involved determine the terms of the agreement.
Futures contracts are bought and sold based on a standard size and settlement date on a public commodities market, such as the Chicago Mercantile Exchange . Every futures contract is written specific to the trade. The exchange on which the contract is written acts as counterpart to the trader and provides clearance and settlement.
Are Margin Calls Available?
Margin calls are in place to ensure that investors cannot lose more money than the balance in their account. These calls are in place to protect both the broker and the investor in the even the market worsens. Most margin calls are executed in real-time and automatically close a position immediately so the market can no longer move any further against a trade. Margin requirements vary among brokers and often depend on the size of the investor’s account. Typically, brokers will contact the investor and request that more money be deposited into the margin account. Alternately, brokers can either close the position or request the investor to close the position to limit risk exposure to both parties.
What is the Broker’s Commission Structure?
Three types of commission are used by Forex brokers; the fixed spread, the variable spread and a percentage of the spread. The spread is the difference between the price the market maker is willing to pay for a currency compared to the price they are willing to sell and an investor a currency; the bid price and the ask price.
To understand how the spread commission types work, look at the following example. An investor is following his/her account online and sees the following quote: “EURUSD – 1.4952 – 1.4955” . The spread is three pips, or the difference between the bid price and asking price. If the broker is paid on a fixed spread of three pips, they will always offer a spread of three pips regardless of market conditions. A broker who is paid on a variable spread will have a pip spread as low as 1.5 or as high as five pips, depending on the currencies traded and market conditions.
Brokers working on straight commission generally charge a very small fee, generally a percentage of one pip, then have a larger market maker, such as a bank or other large commercial institution, actually execute the transaction. These commission generally amount to $2.50 or $3.00 per $100,000 traded . Often commissioned brokers provide investors access to an exceptional proprietary trading platform that investors using a fixed or variable spread broker do not.
Investors should be aware that there may be a middleman involved who also receives a commission from every transaction. If an investor is referred to a Forex broker by another individual, the person who referred the investor often receives a commission for the referral, often on every order executed. Some brokers charge advertising expense in their commissions. Good brokers consider advertising a business expense and do not charge the investor.
Stop Loss Policy?
Typically, Forex brokers do not fill a stop until a minimum of three points is met. For example, an investor who orders a stop loss at 1.2150 will not have their stop honored unless the market trades at a minimum of 1.2147. If the broker trades on the market at 1.2155 and their rate is 1.2150-1.2153, the investor is stopped at 1.2150. Often the low trade may actually be 1.2155 and unscrupulous brokers to run a “low ball” rate and run every investors stop. This means the brokers’ buy at 1.2150 from the investor and sell to the bank at the current market price of 1.2155 .
Investors who use an order book of stops have the ability to use the stops to offset an undesirable market position or to obtain a favorable position. Forex brokers that do not offer concurrent offsets of their investors’ transactions with the Banks are market makers and have the fiduciary responsibility to treat every investor’s transaction with honesty and integrity . Brokers must take each stop seriously. When looking for a broker, investors must be sure that the broker is not creating a scenario in in which they can clean out an investor’s account.
Market makers, or liquidity providers, are the institutions that provide the liquid capital for the Forex market. The market maker connects traders and brokers to create the marketplace. The partnership provides increased liquidity and drives down spreads which reduces the cost of trading . Market makers buy and sell only from their own clients. In exchange they profit from the bid-offer spread which helps expedite trades and lowers trade costs. The market makers in Forex are generally the big banks and other financial institutions in each country.
A broker must have three vital items in place prior to beginning their trades.
- A trading platform
- A technically sound back office
- A bridge interface that establishes a connection with the Forex market
The bridge interface allows brokers to receive price quotes from the market makers. Brokers use the Application Protocol Interface (API) to send instructions to the market maker and, in return, the brokers receive quotes. Large brokers generally have connections with several market makers which provide flexibility on pricing. Small brokers generally work with a single financial institution. Size is not indicative of success. There are hundreds of market makers and every broker interacts with only a small percentage of them.
Some investors see very tight spreads, often as low as 0.9 pips. However, to take advantage of this spread, they must obtain a requote from their broker. Some brokers will “requote” an order every time the market changes in the investor’s favor. Remember that tight spreads improve the investor’s profit, so the tighter the spread, the greater the profit. A good broker will offer a no requote policy and allow the investor to utilize an investment with a tight spread. Alternately, the broker should openly state they offer the tightest spreads available, but they will agree to requote during times of extreme market volatility, breaking economic news that affects the currencies involved or any other important announcement that can affect the currencies’ value.