This is one of the most talked about advantages in Forexthe commission-free trading! Unfortunately, while we all think forex brokers are just executing trades for fun, the simple truth is that everyone needs to make money, even brokers. While they may not charge traditional commissions, forex brokers can still make money when trades take place. Brokers are actually compensated in a number of ways, including:
- Buy/sell currency
- Interest on deposited funds
- Convert and hold currencies
- Rollover fee
The majority of a broker’s income comes from the buying and selling of currencies. They earn this money through so-called spreads, or the difference between the asking and bidding prices of a currency pair. Ask price is the price a retail forex trader pays for a position. The bid price is the amount at which the investor can then sell the position.
The smallest unit of measurement in Forex trading is called a pip, which is equal to 0.0001 (except for the Japanese yen, which is 0.01). The difference between the ask price and the bid price is usually only 3 or 4 pips, which is what brokers do when buying or selling currencies.
The broker is actually a middleman and never charges anyone directly. Instead, the broker buys a position from a larger investment institution and then sells it to a retail forex trader, pocketing the difference between the two. For example, a broker might set the ask price at 1.250 and the bid price at 1.246. If the investor sold the position immediately, the highest price they could sell would be the bid price of 1.246 or a loss of 4 pips. Since a typical Forex trade is made with a lot size of $100,000, this means that the broker makes $40 on that currency exchange.
Spreads will vary depending on the broker and the currency traded. Usually, the spread is between 3-5 pips on average. Unfortunately, brokers are an essential tool in the forex trading game, if only for trade size reasons. About $1.8 trillion is traded daily in Forex, which is traded in $100,000 lots (and $10,000 in mini lots and even micro lots). Therefore, Forex trading is usually highly leveraged and most traders only invest $1,000 (or 1/100th) of their capital.
Forex brokers tend to be partners or have some connection with investment banks and similar institutions. These proponents actually guarantee that loans for leveraged forex trading can be traded in the currency market without any of us, unless we are willing to take the 1%+ risk that most brokers require. Yes, brokers do make money when investors trade on Forex, but they do provide a real service. Investors try to cover losses by turning around and investing before doing their homework. Therefore, be wary of any Forex broker that facilitates any form of day trading or similar, a risky strategy used in the most volatile and liquid markets.