The forex market is one that has historically been limited to huge market players such as governments, big banks, and large institutional investors, and a lot of the trades that are placed in the market and a lot of the money that changes hands does so for purposes other than speculation.
Governments may be looking to manipulate the exchange rates of their currency for instance, or banks may be using the foreign exchange market to settle transactions, and both of these involve a huge amount of volume of currency exchange, where trillions of dollars’ worth of money changes hands every day as a result of these needs.
The forex market is also used a lot for hedging purposes, to reduce the risk of exposure in a given currency or to hedge future payments in a currency, where the purpose of this isn’t speculation, but instead risk management.
This all comprises the overwhelming majority of the forex trade, and using forex trading for speculation purposes takes a big back seat. Among those who speculate include institutional investors such as investment banks and hedge funds, who by virtue of their size can interact with the market directly as the other big players do.
Forex trading isn’t conducted on an exchange, but rather, on a global over the counter market, which does function like an exchange but do not offer the same access as an exchange would, much like the bond market doesn’t provide the access to individuals like the stock market does.
Individual investors, who usually only have a small amount of money to trade, aren’t going to have anywhere near the volume to trade on the forex over the counter market directly, with a broker that places trades on the forex market for them.
One of the drawbacks of an over the counter market versus an exchange is that over the counter markets aren’t that disposed to access among smaller players, and especially the very small ones such as individuals with a little money on hand to speculate on forex.
Recently, we have seen this all change with the emergence of retail forex brokers, who instead of seeing this market limited to the wholesale market and those who transact larger amounts, they have brought forex trading to the people, in a way that even surpasses what stock market brokers do.
How Retail Forex Brokerages Work
While individual traders can open up accounts with direct to market forex brokers, this does require trade and account minimums that are beyond the means of most individual traders, at least in terms of the amount of money that they may wish to devote to forex trading. Traders generally do not want to devote large portions of their overall portfolio to forex speculation, nor would it usually be wise to do so, unless the trader is very adept and especially good at managing risk.
Even if you are trading forex for a living though, and have a large amount of your funds devoted to this, you may still want to go with one of the new style forex brokers out there that act as a principal in your forex transactions, and there are a lot of them to choose from these days.
The best of these forex brokers offers spreads that are quite close to what you could get on your own trading in the forex market directly, although this does differ quite a bit among them and traders do need to pay a lot of attention to this. Spreads with forex trading may seem to represent only slight differences at first glance, but a lower one can provide big benefits when spread over many trades over time.
In exchange for these slightly higher spreads, the retail forex brokers of today offer the benefit of placing your trades with the broker themselves, and not on the market, and the broker may or may not place your trade on the actual market depending on their needs and strategy. This should make no difference to us other than wanting to see their business be stable and profitable enough, and we do need to look closely at this when we look to select a good forex broker, but many of them are actually very solid and know very well how to run their businesses.
Speed of execution is important when trading, and there’s nothing faster than placing your trades directly with a broker rather than through an intermediary. The broker simply offers you a bid and ask for a currency pair and you just click on whatever trades you want to place and they are instantly filled.
This is distinct from the broker’s traditional role of bringing buyers and sellers together, where if you wish to buy a certain security they will match you up with someone who wishes to sell it at a given price and in a given amount. This is even distinct from a broker filling an order from their own inventory, even though that’s closer, but brokers manage their inventory and you are competing with others with their selling this to you versus someone else.
Your order therefore in a normal market setting would always be in a competitive environment, where the broker may serve as market maker or other market makers would be involved and there are often many paths and means to get an order filled. This certainly adds complexity to getting a good fill even if you are placing orders at the market.
People who trade stocks will pay a lot of attention to order routing and this can make a big difference in their results. With today’s forex brokerages though, this is all simplified to the maximum degree and there is just one bid and ask involved and it is the one that is put right in front of you as a trader on their platform, where you simply click on the trade you want to make and that’s all there is to it.
A lot of retail stock traders don’t really realize the complexity behind order filling by brokerages and may gripe at some of what they perceive as bad fills and slippage, and may not even be aware when they didn’t get that good of a fill if they don’t pay enough attention to the orders in the market, but none of this is ever an issue with a forex broker.
Rather, what you see is what you get and there is of course the risk for slippage but the risk is much less when your order is executed immediately. While markets certainly can move from the time you click until the order is placed, speed is everything here and it doesn’t get any faster than this.
Criteria for Selecting a Good Forex Broker
The first thing we need to do in order to get comfortable with forex trading is to realize that as long as we go with a reputable forex broker, it is perfectly fine and even desirable that our orders only get placed with the broker and not directly in the market.
This does require that we deal with a trustworthy forex broker though, and therefore having this the case is very important. Many forex brokerages are well regulated though and while it’s ideal to have them regulated by the authorities in the country in which you live, being regulated by a respected body in another country is plenty of evidence that they are at least under good oversight.
If we are covered by our own institutions though and especially if we are provided insurance against the brokerage failing, this is of course a real benefit and should sway our preferences accordingly.
We also need to look at the company itself that operates a brokerage to ensure that they are stable and are likely to meet their obligations. Forex trading is a pretty safe environment generally but it does pay to be more diligent when we are vetting our possible choices, and since we only really need one broker to trade forex it pays to look to select a very good one.
Size does matter here and we do want one that has enough assets and are sufficiently profitable to provide the structure to handle the business that they are in. Forex brokerages are exposed to certain risks and this transfers over to us as potential counterparty risk. Good forex brokerages manage these risks well and that’s the business that they are in actually, but they do differ in quality and a large and experienced brokerage will generally provide more peace of mind here over less established ones.
Spreads that brokerages offer overall does differ quite a bit, and many rely on marketing to attract depositors, directed at forex traders and potential forex traders that haven’t shopped around much and may not be aware of these differences or how much they matter.
This is the first thing we need to be looking at when comparing forex brokers though, as while we don’t pay commissions on our trades and that is a tremendous thing, we do pay the spreads and differences in spreads mean differences in trading costs.
Since forex traders are pretty active, this can add up to a lot of money at the end of the year and this comes right off your bottom line, where if you pay an extra half a pip and you place 100 trades, that adds up to 50 pips per 100. Over thousands of trades this adds up to much more than this and this is money that could have been in your account but is instead in theirs.
While going with a trustworthy, solid, and proven forex broker and getting good spreads are musts, and we really need both, there are other things that allow us to make further refinements in our choices, such as convenient means of depositing and withdrawing, the breadth of a broker’s offerings, their account and trade minimums, their margin rates and charges, the quality of their trade simulation software and how long they will allow you to use it, and their level of customer service.
These other considerations are important, but certainly less so than stability and price, which are the two cornerstones of a great forex broker. The best tend to tend to have good amenities as well, but these other factors can still influence our choices as well, especially if they are important to us.
The bottom line is that most traders do not spend near enough time exploring the competition here when they decide to go with a forex broker. You just don’t want to jump at the first one you see of course, and this is a decision that really will matter to your forex trading. Once you find a great forex broker you can be set for the long term and this is a decision that does really matter so it does merit some time and thought to be sure.