How forex brokers work

How does Forex work?

At the beginning of their trading career, there are many aspiring traders who will have trouble wrapping their mind around how Forex trading works or if Forex trading works at all. These questions point to the very heart of the problem – they are taking the wrong approach.

False motives, unrealistic goals, greed, inappropriate haste, lack of effort and insufficient knowledge are the main reasons why many of those who try jump-starting a trading career leave disappointed and empty handed.

Before you do anything, sit back and think about how much there is behind the Forex market and how it works.

Ask yourself the following questions:

What do I know about the basic principles of price formation for every asset in the world? What is the underlying structure of the trading industry? What is the nature of international economic interactions? What are the key principles of fundamental and technical schools of market analysis? What are the psychological intricacies of being a trader? What actually happens when a trader presses a button?

Let's start from the beginning.

First, there was supply and demand.

In economics, supply and demand is a model that explains price formation in a free competitive marketplace. The price of goods is settled at a point where the quantity demanded by consumer is balanced by the quantity supplied by producer.

Let's say you are out there one day doing grocery shopping. You need apples and there happens to be only a single vendor with just the right amount of apples. You negotiate, agree on the price and make the exchange – a set amount of money for a set amount of apples. Both you and the vendor made a trade, getting what you wanted.

The next day, you are out there again looking to buy the same amount of apples, only now there are two vendors, both having the amount of apples you need. This means that there is higher supply of apples then there is demand for them.

The competition between vendors will push the price of apples down since both of them realise you will probably go for the cheaper apples, assuming all other things are equal. A new price will be set and you will make a deal with whichever vendor you see fit.

Alternatively, if that day you came with a friend who is also interested in apples, but only one vendor was there, there would be more demand for apples than supply. A vendor would recognise this and up the price of his apples, knowing that both you and your friend will definitely buy all of his apples.

This is the ABC of economics and it is absolutely vital that you, as an aspiring trader, understand the simple logic of how does this little apple-market works, since it will help you understand how the Forex market works.

Things may start to get more complicated from here on. Applying the apple market scenario to the foreign exchange market, every time a particular currency is bought, surplus demand is created on the market, throwing the price off balance and pushing it higher.

Similarly, every time a particular currency is sold, a surplus supply is created – again, throwing the price off balance and pushing it down.

The amount of impact is directly proportionate to the trading volume per deal. Big players, like national banks, for example, can cause a lot of disequilibrium by tampering with the supply of their home currency. Small players, like retail traders, can only influence the market ever so slightly, but still do through their sheer numbers.

The ever-changing supply and demand of currencies is what makes Forex charts tick. The philosophy of price balancing is key to understanding how online Forex trading works, since all the economic events in the world are relevant to the market only in terms of how much they influence the supply and demand of an asset. Or, it is worth mentioning, how much they influence the projected supply and demand of an asset.

Using our apple market as an example, if one of the apple vendors went bankrupt this season, both you and your friend can expect the price of apples to rise before you even show up at the market.

Draw a mental map of the industry before you get lost.

When considering how the Forex market works it is best imagined as an ever-changing ocean. There are plenty of fish in that ocean, from big to small depending on their buying power. There are multi-billion leviathans like national banks, multinational companies and hedge funds.

Their monetary policy and trading decisions make the biggest waves, throwing prices off balance the most. There are mid-sized fish – private investors, companies in need of hedging and private banks. Then there are the small players – financial brokers, smaller banks and smaller investors.

Most of the abovementioned market participants have direct access to the Forex interbank, which is the market place where all the currency exchanging magic happens. They are allowed to, simply because they are over a certain threshold of funds at hand. This means they can trade with each other without having to go through middlemen .

The smallest players, who can be viewed as the plankton of the financial ocean, trying to survive long enough to grow big is the retail Forex trader, which of course includes you. The buying power of a casual trader is usually so small compared to the big fish that he needs a Forex broker or a bank to provide a financially leveraged trading account and access to the market via trading servers.

Understanding how the Forex market works as well as one's position in the scale of things will inspire the necessary caution needed when trading.

What does any of this have to do with the powers that be?

Forex is the currencies market, as you should be aware by now, and currencies, unlike most other tradable assets, are economic tools as much as they are economic indicators. Roughly speaking, if countries were companies, currencies would be their stock.

Policy makers at central banks are the biggest tweakers of money supply, which makes their monetary policy decisions a major price-influencing factor on Forex trading and how it works.

The most obvious and simple example would be the interest rates set by the national bank of every country in the world that has one. Since the US dollar, euro, British pound and Japanese yen are the most traded currencies in the world, the Federal Reserve Bank, European Central Bank, Bank of England and Bank of Japan are respectively the biggest fish in the ocean.

Understanding how this can affect the economy will help you understand how the Forex market works.

When interest rates are increased, and they can be solely on the national bank's word, it gets more expensive for market participants to borrow that currency from that bank. Momentarily, this causes a shortage in currency supply and pushes the currency price up.

Which is a good thing, right? Who wouldn't want a strong national currency?

Well, not really. Short term, this means less money to play with for business developments, less expendable household income and, ultimately, a slower rate of economic growth. However, this slows down inflation and slows down the inevitable build up of debt – which, in the long term, is a very good thing.

Alternatively, when interest rates are cut, all market participants borrow more money. Momentarily, a surplus money supply is created and the currency price goes down. Short term, this means business expansions, increased household spendings and a growing economy.

Sounds really good?

Well, again, not really. The more money that is borrowed means the more money that is owed. In the long run, the accumulated bank credit comes down on everybody's head like a big storm creating a financial crisis. This is called the macro economic cycle .

This pinnacle is common to all capitalistic-type economies. National banks are continually trying to balance the scales by periodically raising and lowering interest rates. This is called the micro economic cycle .

These economic cycles are much like climate change cycles - slow, unstoppable and very dangerous to the market participants that can't see them coming.

Analysis is the key.

Analysis is not only the key to success in trading, analysis, to some extent is the only thing that makes Forex trading really work.

The two principal schools of market analysis are fundamental analysis and technical analysis.

Fundamental analysis is an evolved form of financial audit, only on the scale of a country or, sometimes, the world. This is the oldest form of price forecasting that looks at the various elements of an economy – its current stage in the cycle, relevant events, future prognosis, and the weighted possible impact on the market.

Fundamental analysis deals with a country's GDP and unemployment rates, interest rates and export amounts, war, elections, natural disasters and economic advancements. Impact is weighted in terms of influence on supply and demand. For example recent advancements in shale oil drilling technologies are promising a steady and increased supply of oil now and in the near future, which has driven oil prices to their decade low in winter 2014/15.

Fundamental analysis requires an understanding of international economics and deals with factors as yet unaccounted for by the market. This school of anaylsis works for investing and long-term trading.

The drawback of this type of analysis is the element of uncertainty that so many inputs create . The advantage of fundamental analysis is that when done correctly, it predicts fundamental price movements that can help generate profit over a prolonged period of time.

Technical analysis is a younger form of market analysis that deals only with two variables – the time and the price. Both are strictly quantifiable, accounted for by the market and are both undeniable facts. This is why for many, Forex trading works better when studying charts rather than making economic inquiries.

Whether you are drawing support and resistance lines, identifying key levels, applying technical indicators or comparing candlestick formations - you are figuring out how online trading Forex works without looking into causes for supply and demand. Technical analysis can be used for both short and long term trading purposes. It is the only thing available to quick-style traders like scalpers, who make their profit from the infamous daily volatility on Forex rather than trend following.

The strength of the technical approach is in analysing quantifiable information precisely as it has been accounted for by the market. The drawback is that it has already affected the market. To trust the outcomes of technical analysis one should subscribe to the notion that price formations in the past may have an effect on price formations in the future, which to many fundamentalists seems ridiculous.

Putting it simply, fundamental analysis is an economic detective with elements of future forecasting, while technical analysis is visual price-time archaeology, combined with statistics.

Fortune favours the prepared.

Lack of preparation is the very reason why so many aspiring traders fail before they ever manage to figure out how Forex trading works.

Numerous books are written about the trader's psychology and how to avoid the pitfalls that a trader's mind is keen on slipping into. Again, the problem is the approach and it is easy to get confused when everything is new.

Some Forex brokers, due to the nature of their business, often pitch Forex as a pseudo-scientific gambling attraction that is basically like flipping a coin only with a somewhat better methodology.

As a result of such marketing, newcomers come with little or no training, expecting to make fortunes out of $10 in a few decisive clicks of a mouse. They jump into the market full of hope and the market spits them back out, disappointed and empty handed.

The majority of Forex traders lose money and their broker's business model is well adjusted to that trend. This is neither good, nor bad – this is the reason thanks that the market exists. Every time you close with profit, somebody else has to close with a loss.

Getting back to our point about being prepared, there's nothing that would prepare you better than demo trading – a risk-free way of trading in real-time conditions to get a better feel for the market. It is highly recommended to immerse yourself in demo trading first and only then moving on to live trading. The results will speak for themselves.

How does Forex trading work from a practical standpoint?

A currency value is measured through how much of another currency it can buy. This is called a price quote. There are always two prices in a price quote - bid and ask. The ask price is used when buying a currency, while the bid price is used when selling. Note that the ask price of any financial instrument is at all times higher than the bid price. Thus, a bank will always buy your currency a bit cheaper and sell it to you at a higher rate. The difference between bid and ask is called the spread.

Both bid and ask prices are communicated between market participants almost instantaneously at all times except when the market is closed. A trader receives quotes via the internet from the brokerage firm who provided the trading account for him. In turn, the broker firm receives price quotes from its liquidity providers – banks.

Generally speaking, the more liquidity, the tighter the spread, which is better for everybody. Usually trading is ongoing, conducted smoothly and liquidity is plentiful. However there are times, like during major news releases, when price gaps occur due to major price shifts over the shortest periods of time.

The rest is simple Forex mechanics. Trading takes place on the chosen Forex platform at the click of a mouse. When, for example, a buy order is placed on EUR/USD pair, a portion of funds from the trader's account is used to purchase the pair's base currency – in this case the euro – and sells the pair's quoted currency – US dollar.

The broker does this and it is called placing a buy order. The order is placed either with the broker (Market Maker) or communicated directly to the Forex interbank market (ECN execution), where the big players are. It is important to understand that a trader can place an order to sell a currency that he does not 'own'.

Next, depending on the trading strategy, a trader waits until the purchased currency grows in value, relative to the sold one. When the accumulated profit is satisfying to the trader, he closes the order and the broker does the opposite set of transactions - sells euros and buys dollars. A reverse process takes place when a trader places a sell order.

The concepts of buying and selling in Forex can be confusing at first, since in every trade one currency is exchanged for another, meaning there is always both buy and sell in every trade. For a beginner trader, it might be easier to think of a currency pair as an abstract financial instrument to which a price is assigned by the market.

Now you know the main driving forces of the market, its underlying structure in terms of key players, two main schools of market analysis and how online Forex trading worls from a practical standpoint.

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How Forex Brokers Make Money.

In the foreign exchange market, traders and speculators buy and sell various currencies based on whether they think the currency will appreciate or lose value. The foreign exchange, or forex, market is high risk and sees more than $5 trillion dollars traded daily. Traders have to go through an intermediary such as a forex broker to execute trades. No matter the gains or losses sustained by individual traders, forex brokers make money on commissions and fees, some of them hidden. Understanding how forex brokers make money can help you in choosing the right broker. ( Related 5 Tips For Selecting a Forex Broker)

Role of the Foreign Exchange Broker.

A foreign-exchange broker takes orders to buy or sell currencies and executes them. Forex brokers typically operate on the over-the-counter, or OTC, market. This is a market that is not subject to the same regulations as other financial exchanges, and the forex broker may not be subject to many of the rules that govern securities transactions. There is also no centralized clearing mechanism in this market which means you will have be careful that your counterparty does not default. Make sure that you investigate the counterparty and his capitalization before you proceed. Be vigilant in choosing a reliable forex broker. ( Related Top 10 Forex Brokers For Beginners)

In return for executing buy or sell orders, the forex broker will charge a commission per trade or a spread. That is how forex brokers 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 you will receive for selling a currency, while the ask price is the price you will have to pay for buying a currency. The difference between the bid and ask price is the broker’s spread. A broker could also charge both a commission and a spread on a trade. Some brokers may claim to offer commission-free trades. Actually, these brokers probably make a commission by widening the spread on trades.

The spread could also be either fixed or variable. In the case of a variable spread, the spread will vary depending on how the market moves. A major market event, such as a change in interest rates, could cause the spread to change. This could either be favorable or unfavorable to you. If the market gets volatile, you could end up paying much more than you 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. Thus you have to pay close attention to pricing.

In general, the brokers who are well capitalized and work with a number of large foreign exchange dealers to get competitive quotes typically offer competitive pricing.

Risks of Foreign Exchange Trading.

It is possible to trade on margin by depositing a small amount as a margin requirement. This introduces a lot of risk in the foreign exchange market for both the trader and the broker. For example, in January 2015, the Swiss National Bank stopped supporting the euro, causing the Swiss franc to appreciate considerably versus the euro. Traders caught on the wrong side of this trade lost their money and were not able to make good on the margin requirements, resulting in some brokers suffering catastrophic losses and even going into bankruptcy.

Those contemplating trading in the forex market will have to proceed cautiously—many foreign-exchange traders have lost money as a result of fraudulent get-rich schemes that promise great returns in this thinly regulated market. The forex market is not one in which prices are transparent and each broker has his own quoting method. It is up to those who are transacting in this market to investigate their broker pricing to ensure that they are getting a good deal.

How Do Forex Brokers Work?

Ever wondered how forex brokers work? How they make money? To answer these questions, you need to understand the different types of forex brokers and their various business models. Unlike humans, not all forex brokers are created equal. Some are much more competitive than others and some, are just outright scammers. Sadly it’s not always easy to tell the difference between the two, some of the oldest and most famous names in forex are notorious for shady and underhanded tactics. In this article we will discuss the various types of forex brokers and why it’s important to trade with a true ECN broker.

Market Makers and Spreads.

All forex brokers will tell you they make their money off the spread (the difference between the buy and sell price), however lots of brokers actually only derive a small portion of their income from spreads. How do they make money then you ask? Simple. By trading against their clients.

These brokers are known in the industry as market makers. The problem is, the vast majority of forex brokers actually operate in this manner. When you first start out trading you assume you are buying and selling from other participants in the market: if you make money, someone else is losing money and vice versa. This is true to a point, but often this ‘someone’ is a lot closer than you think … it’s your broker!

The vast majority of new traders lose money, that’s a fact. If they continued to trade and addressed shortcomings in their strategy and psychology, they would likely improve and end up becoming profitable, but many just aren’t up to the challenge and leave as losers. Market makers are not only fully aware of this, their entire business model revolves around it. Market makers make money when their clients lose, simple as that. This is a glaring conflict of interest, rather than the broker making money when the client wins and continues to trade, they actually have a vested interest in their client losing!

The market maker game is to recruit new traders by the hundreds, offer some free, substandard education, or a bonus. Even if the new trader is lucky to begin with and makes money off their bonus, they will likely then make a much larger deposit which they eventually lose.

Because of the inherent conflict interest involved in making a market, some (though not all) market makers have been known to engage in some extremely nefarious tactics. There are horror stories of unexplainable spikes, spread widening, stop hunting and even refused withdrawals and closed accounts!

STP Forex Brokers.

STP is short for Straight-through Processing, STP brokers essentially operate on the model you thought your market making broker used: they make their money off the spread and you are actually trading against other participants in the market. STP brokers aggregate prices from their liquidity providers and add a small markup, you place your order with the broker, the broker passes the order on to their liquidity provider (retaining the small difference in spread). Because you are trading against other participants in the market and not your broker, STP brokers have no interest in you losing. In fact, if you lose money and stop trading, then you are no longer earning your broker money.

The STP model is a huge step up from the market maker model and Vantage FX offers this model to all clients on our standard accounts with a minimum first deposit of only $100. Even so, many professional traders and scalpers find the third brokerage model to be cheaper: true ECN.

True ECN Forex Brokers.

True ECN is the logical conclusion of the STP model and is favoured by the vast majority of professional and high volume traders. As far as execution is concerned, the model is almost identical to STP: you are trading against other participants in the real forex market and not against your broker. The primary difference between STP and true ECN is that ECN brokers don’t make their money off spreads, but instead charge a small flat commission charge on each trade. There is zero spread mark, the spreads offered on true ECN accounts are razor sharp, often as low as 0 pips. These are very best prices available in the real forex market right at the time. Razor-sharp, zero mark-up spreads and transparent fixed fees make ECN accounts the favoured option for scalpers, professional traders and traders running automated systems that are adversely affected by wider spreads.

Just like the STP model, there is zero conflict of interest between the trader and broker when trading on a true ECN account. Your true ECN broker wants you to succeed in trading, grow your account and begin to trade size. The more size you trade, the more your broker makes. This is the way it’s supposed to be, with the broker and client’s interests in perfect alignment.

ECN accounts were formerly only available to high net worth and institutional clients, but over the past few years traders have become more savvy and there has been increasing demand for the best deal from retail clients.

So now you know …

We hope you have enjoyed this piece on the different types of forex brokers and how they work. In summary, market makers are the most expensive option for trading and actually make money when their clients lose, bad spreads are only part of the story, some traders have experienced a lot worse! STP brokers on the other hand are a huge step up and a great option for traders who are just getting started on their trading journey. When it comes to serious professional trading, scalping or automated trading though, there is only one option: ECN.

How Does Foreign Exchange Trading Work?

Foreign exchange trading was once just something that people had to do when traveling to other countries. They would exchange some of their home country's currency for another and endure the current currency exchange rate.

These days, when you hear someone refer to foreign exchange trading, they are usually referring to a type of investment trading that has now become common. Traders can now speculate on the fluctuating values of currencies between two countries.

It's done for sport and profit.

Beginner Trading.

It seems like something that most people would find easy, except, in this particular industry, there is a high rate of failure among new traders. Even traders that are aware of that tend to start out with the attitude of "It happened to them, but it won't happen to me." In the end, 96 percent of these traders walk away empty handed, not quite sure what happened to them, or maybe even feeling a bit scammed.

Forex trading is not a scam; it's just an industry that is primarily set up for insiders that understand it. The goal for new traders should be to survive long enough to understand the inner working of foreign exchange trading and become one of those insiders.

The number one thing that hangs most traders out to dry is the ability to use forex trading leverage. Using Leverage allows traders to trade on the market with more money than what they have in their account.

For example, if you were trading 2:1, you could use a $1,000 deposit, to control $2,000 of currency on the market. Many forex brokers offer as much as 50:1 leverage. New traders tend to jump in and start trading with that 50:1 leverage immediately without being prepared for the consequences.

Trading with leverage sounds like a really good time, and it's true that it can increase how easily you can make money, but the thing that is less talked about is it also increases your risk for losses.

If a trader with $1,000 in their account is trading with 50:1 and trading $50,000 on the market, each pip is worth around $5. If the average daily move is 70 to 100 pips, in a day your average loss could be around $350. If you made a really bad trade, you could lose your entire account in 3 days, and of course, that is assuming that conditions are normal.

Most new traders being optimistic might say "but I could also double my account in just a matter of days." While that is indeed true, watching your account fluctuate that seriously is very difficult to do. Many people start out assuming that they can handle it, but when it comes down to it, they don't, and forex trading mistakes are made.

Avoiding Mistakes.

Assuming that you can manage not to fall into the leverage trap, you'll need to have a handle on your emotions. The biggest thing that you'll tackle is your emotion when trading forex. The availability of leverage will tempt you to use it, and if it works against you, your emotions will have your vision upside down, and you will probably lose money. The best way to avoid all of this is to have a trading plan that you can stick to. Not only should you have a trading plan, but you should keep a forex trading journal to keep track of your progress.

You might feel when looking around online, that other people can trade forex and you can't. It's not true; it's just your self-perception that makes it seem that way. A lot of people that are trading foreign exchange are struggling, but their pride keeps them from admitting their problems, and you'll find them posting in online forums or on Facebook about how wonderful they are doing when they are struggling just like you.

Winning at trading forex online is an achievable goal if you get educated and keep your head together while you're learning. Practice on a forex trading demo first, and start small when you start using real money. Always allow yourself to be wrong and learn how to move on from it when it happens. People fail at forex trading every day for lack of ability, to be honest with themselves.

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If you learn to do that, you've solved half of the equation for success in forex trading.