As a rookie, trying to start actively trading, you might have a lot of simple questions regarding the forex market. One of these questions is where does the money come from in Forex. Let’s learn some important things about how the Forex trading market works and where the profit and market liquidity come from.
Where does the money come from in Forex: Tips for actively trading Forex?
Profitable traders and investors who trade stocks, futures, or options use a broker who acts as a transaction agent. The broker attempts to execute the trading orders according to the client’s instructions. For this service, he receives a commission when the client buys and sells a tradable instrument.
The forex market has no commission in the classical sense. Forex brokerage is a sort of dealer; this is a crucial distinction that all investors should understand. Market maker brokers who assume the market risk by acting as the client’s counterparty do not charge any commission; they make money through the bid-ask spread (the difference between the offer to buy and sell).
Where does the money come from in Forex: Trading commissions
Forex brokers use three forms of commission. As we mentioned above, these are called spreads. Some companies offer a fixed spread, others offer a variable spread, and still, others charge based on a percentage of the transaction volume. Which is the best choice? At first, it seems that the fixed spread is the right choice because then you know what the charges are upfront. However, before making your choice, there are a few things you need to consider.
The spread represents the difference between the buying and selling price. For example, if the EUR/USD quote is 1.4010/1.4013, that represents a spread of three pips. Suppose you are dealing with a market maker who offers a fixed spread of three pips instead of a variable margin. The difference will always come to three pips, no matter market volatility.
In the case of a broker that offers a variable spread, you can expect spreads, which can sometimes be one pip or much higher, depending on the currency pair and the market volatility.
Some brokers provide the inter-bank price feeds with very tight spreads. In this case, they charge a meagre commission, maybe two-tenths of a pip.
Where does the money come from in Forex: ECN brokers
However, some ECN brokers (ECN – electronic communications networks) who offer direct access (STP) to the currency market do not gross up the spread. They only act as an intermediary between liquidity providers and forex traders. ECN brokers, therefore, charge a commission on each transaction. With an ECN broker, the trader benefits from very low or even zero spreads at times.
On the foreign exchange market, prices are quoted up to the fourth decimal (5 decimal places sometimes). For example, if the bid and ask price of EUR/USD (Euro against the Dollar) is 1.5000/1.5002, the spread is two pips. A pip stands for “point in percentage,” it is the smallest variation of a currency pair. One pip is generally equal to 1/100 of 1%. Among the major currencies, the only exception to this rule is the Japanese yen. A pip on the Japanese yen is worth around the US $ 0.01, so on the USD/JPY pair, the quote is only two decimal places (i.e., 1/100th of yen, instead of 1/1000th with other major currencies).
With an ECN broker, the book of orders is disclosed in real-time, making the currency market a transparent playground for all. All players benefit from all the information crucial for their operations, always in real-time. As for the broker’s compensation, this is usually done based on the volume traded, taking the form of a commission. It can become quite high, depending on the volume traded by the retailer.
Currency supply and demand make Forex market working
For a market to work, sellers and buyers are inseparable factors. It brings together banking institutions, traders, not to mention market makers. For its part, the ECN broker ensures that orders from its clients are matched. If an order is not “matched”, the broker requests a liquidity provider.
Banks offer the possibility for clients of an ECN broker to benefit from good liquidity and attractive spreads (note that these are variable with this type of broker). However, these spreads can rise sharply when the trend is highly volatile (after the revelation of major economic news, for example). In the event of a strong announcement, the spread on the main EUR/USD currency pair could reach ten pips.
One’s loss, other’s gain
Theoretically, what you win another loses it. The money you are going to make is money created by someone’s losses, fees, and lost deposits or the retail traders who set the stop loss too early. Many newbies think they have the miracle strategy, which will always work, but it happens they lose money. So watch out for all the strategies you will find on forex sites. Train well in demo mode, even if it should take you a couple of months.