This tutorial will help you understand what a Forex broker is and how they can help (or hinder) your trading career. It's a perfect article if you're just getting started in Forex and want to learn very basic concepts.
A Forex (foreign exchange) broker is a financial services company that holds your money in their account and gives you the ability to use that money to buy and sell currencies, so that you can potentially profit from the trades. Brokers provide customers with access to liquidity providers, which are the “exchanges” where the currency pairs are actually traded. Some brokers may also take the other side of a trade, in order to help you get your trade filled.
Now let's get into the details of how brokers work and why you need them.
The Different Types of Brokers
In Forex, there are basically 2 types of brokers:
- Dealing desk, also known as market maker
- Electronic Communication Network (ECN), also known as a “non-dealing desk” broker
Each type of broker has its benefits and downsides.
A dealing desk broker takes the opposite side of some customer trades, if they cannot find another trader to match your trade with. When a reputable dealing desk broker takes your trades, they play fair and generally allow you to take a trade that you may not have been able to get at an ECN broker.
One big upside of a dealing desk broker is that they can take less of a fee per trade than ECN brokers, especially for traders with small accounts.
ECNs are generally thought of as more “fair” because they do not take the other side of customer trades. They simply match customer orders with each other.
These brokers usually charge a commission on every trade, and offer a lower spread, which benefits traders with larger accounts.
The downside to ECNs is that they might not be able to match your order with another trader on the opposite side and they may end up canceling your order. Since they don't take trades themselves, they cannot step in and take the trade.
There's no right or wrong answer when choosing between a dealing desk or non-dealing desk broker.
It all depends on the brokers available in your country and what makes sense in your situation.
What is a Liquidity Provider?
A liquidity provider is a company that provides access to trading markets. These trading markets can include banks and large institutions.
Brokers have connections to multiple liquidity providers, which allows them to find the best prices for their customers.
Liquidity providers do not take on retail (independent) traders like you and me because they only want to be in the business of providing market access.
They leave it up to the brokers to find retail customers and deal with customer service.
Examples of Forex Brokers
Here are some of the biggest brokers, at the time this article is being written.
- Oanda
- Pepperstone
- Forex.com
- Saxo Bank
- Dukascopy
- Scandinavian Capital Markets
- See our recommended brokers
Some brokers specialize in working with customers in only certain parts of the world, so do your research and find out which brokers are the best option where you live.
How Do Brokers Make Money?
There are 2 ways that brokers make money. They can charge a bid-ask spread and/or charge a commission on every trade.
The bid-ask spread is the difference between what you can buy a currency pair for and what you can sell a currency pair for.
You buy at the bid and sell at the ask.
So as soon as you buy a currency pair, your account immediately shows a small loss, because you have to sell at the ask price, which is lower than the buy price.
…and vice versa if you sell a currency pair first.
A commission is a flat fee on every trade.
Usually dealing desk brokers only charge a spread, but the spreads are wider than at ECN brokers. ECN brokers generally provide smaller spreads, so most also charge a commission to make up for the small spread.
For traders with larger accounts, the additional commission can still come out cheaper than paying the larger spread with a dealing desk broker.
Avoid brokers that charges you a monthly fee or an expensive withdrawal fee (beyond a basic transaction fee). Reputable brokers usually won't charge these fees.
Also avoid brokers that charge a monthly inactivity fee. This is a fee that you have to pay if you don't make a certain number of trades per month.
Some brokers will also offer other products and services for sale to create income.
Forex Leverage Explained
Most Forex brokers allow you to trade with leverage.
Leverage is a good thing to have in Forex because if you traded without it, you would barely make any money on your trades.
Most currency pairs move in the equivalent of pennies in US Dollars per day. Therefore if you did not have leverage, you would only make (or lose) a small amount on every trade.
However, if you trade with leverage, every currency unit in your account, $1 for example, would control many times that amount of currency.
For example, if you trade with 50:1 leverage, every dollar in your account now controls $50 of currency. If you put on a trade using $100 in your account, you now control $5,000 worth of currency, at 50:1 leverage.
If the price goes against you by 10%, you would lose $500, much more than the original $100 in your account.
Obviously, the trade could also go in your favor, leading to a big gain.
But if you did not use leverage, you would only gain or lose $10 on the same market move, because your profit or loss would only be calculated on the original $100.
Therefore, leverage amplifies gains and losses and should be used responsibly.
That's a very simplified version of how leverage in Forex works, but you get the point.
Broker Regulation
One important thing to consider when choosing a broker is if a broker is regulated or not. Make sure that they are registered with the regulating organization in the area you live.
There are several dodgy, unregulated, fly-by-night brokers that come and go every year. Here's an example of one.
Here are a few examples of regulating organizations around the world:
- Commodity Futures Trading Commission
- National Futures Association
- Swedish Financial Supervisory Authority
- Financial Conduct Authority
- Danish Financial Supervisory Authority
- Finantsinspektsioon
- And many more!
These organizations provide varying levels of protection against fraud and broker bankruptcy. So be sure to understand how things work in your country.
Find the organization that regulates brokers in your country, then only deal with brokers that are on their “approved” list.
Can You Trade Forex Without a Broker?
Technically, yes.
You can take your physical currency and find someone who is willing trade it for another currency. Then you would have to another person who is willing to trade that currency for your original currency, in order to realize your profit or loss.
So in a practical sense, it's not possible to trade Forex without a broker.
Even if you go to a bank or an exchange window at a store, they are acting like a broker, but they won't give you leverage.
Since you aren't getting leverage, it won't be worth your time.
Therefore, just open an account with a Forex broker…it's much easier.
What's the Best Forex Broker?
The best Forex broker will really depend on where you live and how much money you have to trade.
There is no one best Forex broker for everyone.
As I mention here, beginning traders with a small account are probably better off starting with a nano lot, market maker broker.
If you have a larger account and you're consistently profitable, then an ECN broker is usually a better option.
Keep in mind that all brokers will have negative reviews against them.
This is normal.
There are many people who try trading because they think it's easy. When they realize that it's not that easy, they start blaming everyone for their losses…especially their broker.
So try to read between the lines to find out of a review is credible or not. Is the reviewer bringing up a valid point about the broker, or are they just someone who doesn't want to take responsibility for their poor trading results?
Once you find a broker that you feel is good, open a small account and start trading. It also helps to try to withdraw some of your money to see how easy the process is. You can always put it back later.
Conclusion
So that's what a Forex broker is and how they work. In future articles, I'll get into the details on how to select a broker, how to fund an account, and much more.
If you're a beginner and have a question about Forex trading, feel free to contact us and ask a question.
Also take our free beginner's course to jumpstart your trading education.
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