Written by GuruTheSizzle
Public Theory # 1
Less than a decade ago in 1999, retail or individual forex trading simply did not exist. Trading the foreign exchange markets was pretty much restricted to big banks, hedge funds, and high net-worth individuals simply because of the capital requirements for trading. The minimum trading size was usually $1,000,000 USD.
However, as information began spreading about the profit potential that forex trading holds, more people wanted in, even if they could not trade on the traditional interbank market because they did not have huge sums of money to work with.
There was a growing need for forex market access for those investors who had around $10,000 to $50,000 to invest or less, and so the retail forex market was born. New forex brokers began (and still are) springing up rapidly to meet this high demand, yet this aspect of forex trading is still highly unregulated.
Many of the forex brokers out there operate under the ‘market maker’ or bucketshop model, and these are the guys who actually have NO interest in seeing you succeed as a trader. Why? do you ask?
Well, it is their job to make forex market access available to smaller investers (hence the term market maker). In order to do that, they need to be able to fill every order that you place on your trading platform, and they do this by taking the opposing position of every trade that you make.
Well, since they will have an opposing position open for every trade that you make, they will actually lose money every time you have a winning trade. Imagine that you bought the EUR/USD pair because you think the Euro is going to appreciate. Well, in order to provide market access to you, the broker will have to take a position where they are selling EUR/USD in order for your trade to go through.
Since they are in a sell position here, it is in their best interest for the Euro to depreciate in value, or to see you lose on the trade. And keep in mind that your forex market maker will never, ever reveal this to you, as they count only a small minority of traders actually fully understanding their business model, and thus the majority of traders will fall victim to it.
The other type of forex broker business model is called an Electronic Communications Network (ECN), and it is more trader-friendly simply because the broker does not have a vested interest in seeing you fail. In order to understand how this type of setup works, remember that the goal of any broker is to provide market access and liquidity.
A forex market maker does this by taking an opposing position to every trade you place, but an ECN broker does this buy routing your trade order through their communications network and matching it with another trade (for example, if you placed a buy order on a certain currency pair, the ECN would match you up with another trader selling that same pair).
ECN brokers are really your best choice, as it is much easier to make money using a broker that offers this type of trading setup. Because they have no vested interest in seeing you lose money and instead only care about providing a network where they can match your orders with other traders, you would never have any problems withdrawing your profits as you might have with a market maker.
Public Theory # 2
Trading forex is great – online access to your account so you can trade anywhere in the world, very high leverage which enables you to make a significant amount of money from a very small account, the trades are commission-free and even the spreads in forex are extremely tight.
Given that you, the forex trader, has a number of advantages, have you ever wondered how your retail forex broker makes money? And why are there so many retail forex brokers out there? After all, forex broker advertisements are everywhere and the competition seems to be very stiff. So how, exactly, does your forex broker make money?
The answer might surprise you. Your forex broker assumes that you will lose money over the long run when you trade. Given that 95% of forex traders lose money, it is a very safe assumption. Every broker has to decide whether a new account will belong to the group (95%) of traders that loses money, or the group (5%) that makes money.
If I gave you a coin and said that it would land on heads 95% of the time, I think you would probably want to keep the coin so that you could use it to win some bets with your friends and 2) always assume the coin would land on heads.
This is precisely what your forex broker does. Every new account is assumed to belong to “group B” – those traders that will lose money. Since 95% of the traders belong in this group, your broker is only too happy to assume that you belong in this group.
After some time, if you have consistently made profits, your broker will re-assign you to “group A” – these are the lucky 5% of traders who consistently make money. After you have joined this group your broker will lump your trades with all of the rest of group A and hedge against your trades. So, for example, if all traders in group A have bought the EUR/USD your broker will place a trade in the interbank forex market to offset any profits group A make on this trade.
Basically, your broker puts up with group A traders but is really interested in gaining group B accounts. This is because if a trader in group B loses $7,000 – that is, he completely blows up his $7,000 account, then the broker gets all of that money. The broker does not make money on the spread; the broker makes money on the losing accounts.
This is also why brokers are constantly advertising for new customers. The brokers need “fresh blood” to keep making money, many of the traders in group B will give up on trading or move to another broker.
Public Theory # 3
Like any other business in the history of business, your broker’s raison d’etre, is to make as big a profit as possible. There are about as many ways to go about this as there are brokers. For those who are in it for the long haul, however, it is generally best to adopt a set of practices which are deemed fair by their clients: certain boundaries are set, and operating beyond them can cost a brokerage its reputation, and along with it its clients.
Straying outside these boundaries, therefore, is not considered as being in line with the long term goals of the business. How strictly these boundaries are enforced, especially when there is little chance of clients ever even becoming aware of any transgression, again varies from business to business. For the sake of simplicity, in this article we assume that everyone in the business is squeaky clean, as if every client could peek into the broker’s back office at any time and dissect every trade. This is obviously not the case, and many brokers do take advantage of this opaqueness, but the details of that are best left for another discussion.
So without further ado, let’s get into the details of how forex brokers function. Somewhat removed from the top-tier interbank market, retail forex brokers are there to provide a service that would otherwise not be available, that is, giving an investor with a $10,000 bankroll the chance to speculate in the up-until-recently very exclusive forex market. There are generally considered to be 2 types of brokers providing access at the retail level: Electronic Communications Networks (ECNs) and Market Makers. ECNs are generally somewhat more exclusive, requiring larger deposits to get started, but are seen as providing more direct access to the interbank market. As we will see, there are certainly advantages to this, but some disadvantages as well. Market makers, on the other hand are more often than not, the counter party to their clients’ trades, creating somewhat of a conflict of interest, whereas ECNs profit from commission fees charged directly to the clients, regardless of the result of any trade, they are seen as being completely impartial – an ECN has no incentive for a client to lose money.
In fact, one could argue that an ECN stands to profit more if a client is successful, meaning that s/he will stay around longer and they will be able to collect more commission fees from them. A market maker, on the other hand, being the counterparty to a client’s trade, makes money if the client loses money, providing an incentive for some shady practices, particularly in an unregulated market. The extent to which this happens varies among individual brokers. There are also some benefits to trading with a market maker (see our ECNs vs. Market Makers article) Some brokers also provide a service that doesn’t quite fit into either category – they route different orders differently, depending on complex algorithms, or on a dealing desk, that analyze each order and attempt to fill it in the way that will be most beneficial to the broker’s bottom line. They can offset some client orders against one another, effectively creating an in-house market, they can choose to be the counterparty to a client’s trade (trade “against” the client), or they can offset their position with a hedge through a higher-tier counterparty. Note that the market maker is mainly concerned with managing its net exposure, and NOT with any single individual’s trades. They are NOT gunning foryour stop losses specifically, but may be gunning for clusters of stops.
If you have already read the first article in the series, Structure of the Forex Market, you will recall that market mechanics are responsible for the variation in bid/ask spreads, and also for slippage. So it seems the two biggest novice traders’ pet peeves are not so much a function of who their broker is, but rather their lack of understanding of the way the forex market operates. A broker that offers a fixed spread tends not to fill orders during periods of low liquidity because this would expose them to undue risk, and as much as their job is to cater to their clients, remember they are in business primarily to make money for themselves. Some brokers also offer guaranteed order fills, such as “guaranteed stop losses”.
Again, if there is no counter party to take the trade, they have to expose themselves to risk in order to fulfill this guarantee, so don’t be surprised if you see such a broker quoting different/delayed prices around important trend lines or support/resistance levels. Be especially aware of brokers who offer both guaranteed fills AND fixed spreads. When a broker offers something that seems too good to be true, you would be wise to question how exactly their business model is able to support such a risky practice. As a general rule, a broker will help you only when your interests are aligned with theirs. On the other hand, brokers provide a very valuable service, without which you wouldn’t have the opportunity to profit from the forex market, so please think about how it all comes together before blaming your broker for everything
Now a Better Theory & Option (my Choice and Preference)
ever heard of a 3rd type of Broker….. an STP Broker?
Many traders do not feel comfortable trading with “market makers”, as brokers that are market markers have the option of holding on to the other side of their client’s trades which, if they actually choose to do this, would mean that they would profit from their client’s losses and lose money when their clients won. Of course most market makers do not actually do this; market makers usually only seek to match their client’s trades with the trades of other clients in order to profit from the spread and then hedge whatever they cannot match in the market. But nevertheless, many traders are not comfortable with market makers as a Forex Broker actively betting against their clients would be a huge conflict of interest were it to happen.
One solution for those not comfortable with trading with market makers would be to trade with a true STP broker instead. An STP (Straight Through Processing) broker is a broker that is not a market maker, STP brokers are not liquidity providers and therefore all trades placed with an STP broker are immediately passed directly to their liquidity provider(s). As a middleman, an STP broker will profit from the difference between the spread that they charge their clients and the spread that they are able to get from their liquidity provider(s). STP brokers are called Straight Through Processing Brokers because all the trades placed with them effectively pass straight through them and into the hands of someone else.
Trading with a true STP broker is usually a good idea for novice and intermediate traders. The spreads that STP brokers charge are usually very competitive and not normally any higher than those that market makers charge their retail clients, as STP brokers can route their orders to the liquidity provider with the cheapest spread/best price at any given time. And it is in an STP broker’s interests that their clients succeed and make money so that they keep on trading, for novices traders, having a broker that they can be sure is 100% ‘on their side’ is a huge plus.
STP brokers should not be confused with ECN brokers. In order to be a true ECN broker, a broker must provide real time Depth of Market (DOM) information in a window on their trading platform showing every single order to allow traders to see exactly where the liquidity lies. ECN brokers do not simply pass orders straight to a liquidity provider like STPs do, ECN brokers charge a commission for providing a market place where traders can trade against each other on an equal basis, and they don’t actually care about which of their traders wins and which of their traders lose as it doesn’t affect them. An STP broker on the other hand actually wants all it’s traders to do well as that is what is in an STP broker’s best interest.
For those novice and intermediate traders looking for an STP broker I recommend eToro. As eToro is a true STP broker. eToro provides traders with an unlimited practice/demo account and guaranteed stop losses on their live accounts so that there is no risk of DEBT. Making them an ideal broker for novices and intermediate traders to develop their trading skills.
SO, IN SHORT
STP brokers like ‘eToro’ does not have any interest in your loss (which most people doubted so far). Rather they want you to do good for their own benefit… and in this process, they want you to open and close (settle) most positions you can, generating them more positions to pass (LOTs), in turn giving them their own better SPREAD MARGIN
and to get the most out of this, eToro came up with COPY feature and promote the best trader so hard, that most noob copy them and the whole amount generate most total LOTs traded for them, rewarding them with maximum Spread Benefits… as when a GURU holds a position it’s not a Single Lot for them, its multiple lots combined together as a result of 1000’s of traders’ copied equity in the same position through a Single Rate (easy for them to achieve better spreads from their liquidity providers)
and this is the reason they have a Fixed PIP Spread on all pairs… so when they have a bigger combined position, they get most lucrative liquidity Spread, and they make the most out of it… at the same time when they don’t get a better spread from their liquidity provider, they still can generate some margin for themselves as the Final Spread they sell to individual trader is Fixed….
So basically their interest in you is to settle the positions, as many as you can, in profit…. Period
And when they say they have TECH problems when the server throws you out, rates get frozen, etc… is the FACT mostly beyond their own controls at times…. as they only rely on Liquidity Providers (multiple of them, synced together with their system) and a Failure of one to accept/provide will result in these occasional Blockages… they just pass you on… they don’t deal with you…
so i can say it aloud that they are NOT CHEATING anyone…
I hope this will HELP you all Understand the Standards of eToro better and how they make profits in reality….
Compiled by your Trusted: GuruTheSizzle
