How to Choose a Forex Broker
A broker will only make you broker. — Wall Street saying
In the global market, major forex traders, such as banks, use an electronic communication network (ECN) to trade. However, most retail customers must use a forex brokerage, of which there are 2 types: dealing desk brokers and ECN brokers.
Dealing Desk Brokers
When the retail forex market began, most forex brokers were dealing desk brokers that transacted directly with their clients. Acting as the only counterparty to the customer, the dealing desk broker is free to set bid/ask prices. Hence, there was no price competition for a customer's order.
A liquid investment is one that can be sold quickly for a readily ascertainable market price. Liquidity is generally commensurate with the size of the market and the number of trades over a given time period. Forex brokers often advertise that over $4 trillion worth of currencies are traded daily, implying that their customers have the ultimate liquid market. However, customers of dealing desk brokers do not get this liquidity, or even any liquidity at all, since the dealing desk broker sets the prices, which will usually be worse than the market prices that the broker can trade directly on an ECN with other counterparties.
A dealing desk broker profits by earning the spread between what he can obtain from the ECN market in which he trades and the spread offered to his clients, which is why most dealing desk brokers do not charge a commission. Nonetheless, traders are probably paying more — in some cases, much more — for the wider spreads than the commissions charged by ECN brokers.
ECN FX brokers allow their clients to trade directly with a network of counterparties who provide liquidity. ECN brokers typically offer a spread of a pip or less, with price competition being depended on the number and activity of the ECN participants. Because the ECN broker is not a counterparty to the transactions, the broker profits by charging a commission rather than marking up the bid/ask prices. Bid and ask quotes are the best prices offered on that particular ECN. Generally the commission charged is per million traded ("per MIA"). A common commission rate is $100 per million traded, equal to about $10 for a standard contract and $1 for each mini-contract. This is in contrast to dealing desk brokers, also known as non-ECN brokers, who only list the bid and ask prices that they are willing to transact. ECN brokers do not earn the markup, since they are not a direct counterparty, so they must charge a commission.
Disadvantages of Dealing Desk Brokers
Because of the conflict of interest, brokers in the futures industry are forbidden to act as market maker to their clients. However, forex brokers are still permitted to act as market maker to their own clients, which is what a dealing desk broker is. Consequently, there are several disadvantages when dealing with a dealing desk broker. The primary disadvantage is that there is no price competition for orders placed with the broker, so the trader will either pay more or get less from the trade. Furthermore, since the dealing desk broker sets bid/ask prices, the trader can suffer more from requotes, ballooning pip spreads, and stop harvesting.
A requote occurs when the trader places a market order at the bid/ask price, but is filled at a slightly different price. The price difference is known as slippage and tends to occur more frequently with larger contract sizes, larger orders, and when the market is rapidly changing. Some requoting will always occur, because of the time it takes to execute the order, even electronically, but dealing desk brokers can requote simply to increase their own profits. Indeed, many dealing desk brokers 1st trade in the ECN market before they fill their customer's market order, thereby delaying execution even more.
Ballooning pip spreads is a widening of the bid and ask prices during volatile markets. Ballooning pip spreads tend to be greater when dealing with a dealing desk broker rather than an ECN market, since there is always competition in the ECN market. On the other hand, the dealing desk broker will react quickly by increasing the pip spread to reduce his own losses.
Stop harvesting is increasing or decreasing prices to take out stop orders. In a competitive ECN market, this would be difficult, but can easily be accomplished by a dealing desk broker.
The advantage of commissions or markups is that commissions are known, whereas the markup of bid/ask prices by a dealing desk broker is unknown. The trader has no idea what he is being charged for the trades. Some brokers also offer rebates.
Rebates are a marketing tool to attract customers, but any subscribing customers will ultimately pay for the rebates through higher transaction costs, especially with a dealing desk broker. Rebates are generally paid by an introducing broker (IB) that opens an account on behalf of a forex dealer in exchange for a commission paid by the dealer to the IB. A forex dealer may have several IBs working for it, so the IBs compete for customers, which is why some of them offer rebates.
Another disadvantage of dealing desk brokers is that they generally use in-house developed trading platforms, which usually offer fewer options.
Investigating FX Brokers
There is a great deal of fraud in the forex market, so it would behoove the new forex investor to check out the broker thoroughly. One of the best ways to do so is to check if the broker is registered by the National Futures Association (NFA). Because the forex market is largely unregulated, forex brokers do not have to be members of the NFA, but they can register if they want to. If they are members of the NFA, then the firm can be checked out by using NFA's Background Affiliation Status Information Center (BASIC). Here you can find out about the firm, its main principals, and about any regulatory actions against the firm and their resolutions. It is highly recommended that you do not do any business with any broker who is not a member of the NFA. Otherwise, it would be difficult to check the background of the broker, and little you could do if the broker turned out to be less than honest. Other good ways of checking a broker is by talking to other forex traders through the many forums dedicated to foreign exchange.
The NFA has specific registration categories for the brokers who are permitted to offer forex trading. A futures commission merchant (FCM) is an NFA registration category for individuals or firms that may offer both futures and FX currency trading as a counterparty. A FCM is permitted to legally collect client money and to accept buy or sell orders on futures and FX contracts. The FCM is also responsible for issuing account statements, holding client funds, and clearing trades with the futures exchange, if applicable. A retail foreign exchange dealer (RFED) is an NFA registration category for brokerages that act as a counterparty to FX currency traders but not for futures traders. An introducing broker (IB) works as an independent contractor for an FCM. Their main purpose is to acquire clients for larger brokers who actually act as the dealer or provide access to ECNs. In forex, an introducing broker might be affiliated with a RFED rather than an FCM. An associated person (AP) works for an FCM, RFED, or an IB to solicit orders or customers on behalf of their employer. Basically, an associated person is a salesperson or one who manages salespeople. Neither IBs nor APs are permitted to collect or hold customer funds.
Forex Fraud Information from the Commodity Futures Trading Commission (CFTC)
The Commodity Futures Trading Commission (CFTC) has reported a sharp rise in forex trading scams recently. The Commodity Futures Modernization Act of 2000 (CFMA), enacted in December 2000, reasserts that the CFTC has clear jurisdiction and authority to investigate forex scams by both regulated and unregulated companies, and to prevent them from offering or selling foreign currency futures and options contracts to the general public through legal action.
The CFTC has issued a number of advisories and consumer alerts to better educate the public about forex scams and how to avoid them. Some of these links are listed below. The CFTC emphasizes that advertisements promoting investment opportunities which are claimed to be both high return and low risk opportunities should be viewed with skepticism, especially since investments that pay a higher return are also highly risky, since, if they were not, then everyone would invest in the opportunity, which would lower the returns. Consumers should also be skeptical of any employment opportunities in forex trading where easy profits are claimed.
- Division of Trading and Markets Advisory Concerning Foreign Currency Trading By Retail Customers - March 2002
- Advisory on Foreign Currency - February 5, 2001
- Consumer Advisory: Beware of Foreign Currency Trading Frauds
- Consumer Advisory Brochure on Forex Fraud
- Questionnaire Form - to report information to the CFTC regarding forex (or other commodity futures or options) activities
Broker Registration and Background Information
Before you open an account, always check on the company's or individual's status:
Background Affiliation Status Information Center (BASIC) provides information on the members of the National Futures Association (NFA) by listing registration information and futures-related actions contributed by NFA, the CFTC and the U.S. futures exchanges. Additional information can be obtained by calling the NFA's Information Center at (800) 621-3570.
The Administrative Sanctions in Effect List contains the names of firms and individuals that currently have registrations and trading sanctions in effect as a result of administrative and statutory disqualification proceedings.
The Reparations Sanctions in Effect Lists contain the names of individuals or firms who have not paid awards which were levied against them as a result of reparations proceedings.
The Proceedings Bulletin contains information about administrative and injunctive enforcement actions and statutory disqualification-from-registration proceedings.
Another way to compare brokers is to see how profitable their clients are. A new CFTC rule requires that forex brokers disclose the percentage accounts held by the firm that have been profitable in previous quarters. For instance, 1 forex broker reported that 77% of their client accounts were losing money in 2010 and that 72% were in the red in the 4th quarter. Furthermore, 37% of those clients funded their accounts with credit cards. The broker also reported that the average account amount was $3000 and that the broker earned nearly as much on such accounts in transaction costs per year.
Security of Funds
The funds of retail customers held by most forex brokers are not guaranteed, nor are they segregated from the funds of the firm. If the firm goes bankrupt, you will probably be just a general creditor, and may not get all, or any, of your money back. Unlike the funds in a bank account or a stock brokerage account, no government organization guarantees the funds.
Currently, the CFTC requires that a forex firm have a minimum of $1,000,000 of capital, and $5,000,000 if it trades options.
Financial Data for Futures Commission Merchants
More information can be found about futures commission merchants (FCMs) through monthly financial reports that they must file, within 17 business days after the end of the month, with the CFTC's Division of Clearing and Intermediary Oversight. Selected financial information from these reports is published at www.cftc.gov.
Forex Account Types
After finding reputable brokers, you need to gather more information about how they do business, whether they are readily available to answer questions or to resolve complaints. You can do this by reading their website material, by calling them on the telephone to see how quickly and how well they respond, and by getting advice from the many forex chat rooms, including those provided by the broker. Although almost all forex trading is done over the Internet nowadays, sometimes Internet connections don't work, or the company's trading platform isn't working the way it should or the way you think it should, so it is very important that they also provide telephone service.
Many forex dealers allow funding an account with a credit card, but this should be avoided. Most forex trades are already highly leveraged, and by using credit card debt, leverage increases further, since the trader is using borrowed funds for margin.
Most brokers offer regular, mini- and micro-accounts that require trades in specific lot sizes. A regular account trades regular contracts with lot sizes of 100k — that's 100,000 units of currency, so if the broker allows a legally maximum leverage ratio of 50:1, the account will require at least a $2,000 deposit, since that is the minimum to buy or sell 1 lot. A pip is equal to 10 units of currency with 100k lot sizes. If the currency is USD, then 1 pip = $10.
Mini-accounts require a deposit of as little as $200, and lot sizes are usually 10k, so $200 can buy or sell 1 lot worth of currency. A pip = 1 unit of currency. If the currency is USD, then 1 pip = $1. You can generally buy or sell as many lots as you have leverage for, so a mini-account allows smaller increments. For instance, with a mini-account, you could buy or sell $30,000 worth of currency, but with a regular account, the minimum would be 100,000 units of currency, or increments of 100,000 units.
Micro-accounts have lot sizes of 1000 currency units, so even less money is required to trade a micro-account, allowing even greater control over the amount of currency traded in 1 transaction. Note, however, that micro-contracts are usually only offered by dealing desk brokers, who should be avoided because of their disadvantages.
Managed funds are accounts in which the broker does the trading for the investor for a fee.
Many brokers, especially those with international offices, also have accounts for other currencies for traders in other countries.
The most important criteria in selecting a forex broker after assuring yourself that they are reputable is:
- the quality and simplicity of the trading platform,
- the currency pairs offered,
- the spread, which is the difference between the bid/ask prices, which is how the forex broker is compensated.
The best way to assess these criteria is to open practice accounts with several brokers, which most offer, and trade for about a month in each account.
Practice accounts allow you to trade forex using live market data and using the company's software, but without using actual money. It is important to practice with such an account, because forex transactions can be confusing, and using the software will take some learning, especially to use the software proficiently. Practice accounts are a good way to test your ability to actually enter transactions, and that you understand them. If the software doesn't allow you to do something, this may indicate that you do not understand something correctly. Or it could be a bug in the software. Either way, determine what the problem is before risking real money. If you start trading with a mini-account, which is highly recommended, then also start with a practice mini-account. This will give you a better idea of actual profits and losses, both from trades and from interest.
The major problem with demo accounts is that the broker may influence the transactions favorably so that the client seems to be making money, where in a real account, many of the transactions either would not have occurred or the result would have been less favorable. This is particularly true with dealing desk brokers, since they set their own prices. Also consider that demo accounts frequently are more profitable because the trader is not fearful of entering transactions. When real money is on the table, the trader is much more cautious, which often lowers profits or increases losses.
A good way to compare actual trading is to open real mini-accounts with several brokers. Because mini-accounts require very small deposits to open, most people should have no problem opening several accounts to quantify their actual profits, losses and broker fees with each broker, and measure their responsiveness. This also helps if one of the brokers goes bankrupt. At least you won't lose all of your money because you placed it with one broker.
Inevitably, the trader will have some problems with the trading platform, not only because the trader may not fully understand software, but also because the software itself may have bugs. Because money may be at stake, it is important that the trader should be able to resolve the issue quickly, and the fastest means of doing that is through telephone and chat support.
While most currency trades are done over the Internet using the broker's trading platform, it is important that they also provide telephone support, because if anything goes wrong with your computer connection or your computer, you won't have any other way to initiate trades, set limit or stop-loss orders, or close out a position, which can lead to large losses over time.
Chat is useful if you have a problem. It has more immediacy than email, but is usually easier than the telephone. Many problems, especially with the trading platform, require interaction, and chat provides the best method for resolving these kind of problems, since you can chat while actually using the trading software.
Many brokers provide other services to supplement trading activities. These include chat rooms, news, and charting services. While these are nice to have, there is no reason to restrict the use of these services to your broker's, since there are many other websites that also provide these services, and it is likely that there are some websites that will be better than your broker's.
Forums, or chat rooms, allow you to talk about anything with other people. Forums are a good way to find out about other people's experience with brokers, especially if you're not using the broker's forum. It is also a good way to learn about the trading platforms of various brokers, and about potential bugs. If you want to find out more about the trading platform that you are using, then it makes sense to talk to others in the broker's forum, since these people are using the same software that you are.
However, do not take anyone's advice on what trades to make. Use any suggestions as a different view and as a way to consider what you may not have considered otherwise, but most advice about trades is probably not good advice, because the currency markets are very random. No one knows what the currency markets will do in the next moment or the next day, and any advice, even if it turned out to be correct, would become rapidly stale in the fast random walk of currency prices.
Charts are helpful in seeing where currency pairs have been. All currencies trade within a certain range. As one currency trades higher against another, corrective forces limit the ascension. For instance, if the dollar is weak against the Euro, then more United States products will be sold in Europe, because they will be cheaper and fewer European products will sell in the United States because they will be more expensive. This increases demand for the dollar and lessens it for the Euro. Likewise, more Europeans will be inclined to tour the United States because their money is worth more, and fewer Americans will be inclined to travel to Europe because it will be more expensive.
Charts are also used extensively in technical analysis, which tries to predict future prices by extrapolating past chart patterns into the future in the hope that the patterns will repeat themselves more often than not. While many traders use technical analysis for trading, because it is very difficult, if not impossible, to predict currency prices from fundamental analysis, forecasts based on technical analysis are frequently wrong, and long-term forecasts could not possibly have any validity because ultimately, it is the relation of supply to demand that determines prices, and technical analyses cannot quantify this, nor predict changes in fundamental variables, such as the future interest rates of countries.
News can sometimes be a big mover of markets, and it is widely available. The problem with news is that it can be too much, and it can be hard to forecast prices based on the news, since many factors affect currency prices.
Most trading platforms have squawk boxes that deliver the news as it comes out. Most of this information is difficult to read and harder to interpret. Often it is based on someone's technical analysis of current charts, but if one could make money simply by following the advice of technical analysts, then we could all be rich.