What it means
The foreign exchange market is made up of banks and large institutions dealing directly with each other, so smaller traders and companies need a gateway. A forex broker is that gateway, offering a platform where clients can see prices, place orders and track their positions.
Some brokers pass orders to other dealers, while others take the opposite side of the client's trade themselves. Brokers earn money mainly in two ways.
The spread is the difference between the buying price and the selling price, and some brokers also charge a commission on each trade. Costs vary widely, so comparing the total cost of a typical trade is more useful than comparing headline offers.
Many brokers offer leverage, which means a client can control a large position with a small deposit called margin. A 20 to 1 leverage ratio means that a $5,000 deposit can support a $100,000 position.
Leverage increases the potential profit but also the potential loss, and clients can lose more than they expected if the market moves quickly. Regulation is a key point.
In many countries brokers must be licensed, hold client money in segregated accounts (kept apart from the firm's own funds) and follow rules on advertising and risk disclosure. Dealing with an unregulated firm is a common route to fraud, so clients should check the register of the regulator in the broker's home country.
Businesses also use brokers, particularly smaller exporters and importers who want better rates than their bank gives them. A specialist broker may offer forward contracts, which fix a rate for a future date, and give advice on managing currency risk.
The company should still compare the quoted rates with those available elsewhere. When choosing a broker, check how it executes orders, how quickly it pays withdrawals, what it charges for holding positions overnight and how it handles disputes.
Reading the client agreement is dull but necessary, since it sets out the broker's rights, including the right to close positions if the margin runs low.
In practice
Real-world examples.
Example
A small exporter in Ireland receives payments in US dollars each month. She converts about $1,000,000 a year and opens an account with a regulated broker that offers lower costs than her bank. The savings of about 0.3% on each conversion add up to roughly $3,000 a year.
Example
A retail trader opens an account with a broker that advertises very high leverage. He puts in $2,000 and opens a position worth $100,000. A small move against him triggers a margin call (a demand to add funds), and the broker closes the position, leaving him with a heavy loss.
Example
A corporate treasury team compares three brokers for forward contracts. It checks each broker's regulator, asks for sample quotes at the same time and reviews the terms on margin. It picks the broker with the lowest total cost and the clearest contract.
Formula
Calculation
Spread cost = spread in pips x value per pip x number of lots. Margin required = position size / leverage ratio.
Suppose a trader buys 2 standard lots of EUR/USD, which is 200,000 euros. A pip is 0.0001, so each pip on this position is worth 200,000 x 0.0001 = $20. If the broker's spread is 1.2 pips, the cost of entering the trade is 1.2 x 20 = $24. With leverage of 20 to 1 and a euro price of 1.0800, the position is worth 200,000 x 1.0800 = $216,000, so the margin required is 216,000 / 20 = $10,800.Case study
Seen in the real world.
This fictional story is illustrative only. Bluewater Crafts is an invented online retailer that sells handmade goods to customers in several countries and receives payments in euros and pounds.
The owner is paying her bank a high margin on each conversion and decides to look at a specialist broker. She finds that one firm advertises low spreads but is not registered with any regulator, while another is licensed and holds client funds in separate accounts. She chooses the licensed firm even though its quotes are slightly wider.
Over the following year she converts $240,000 and saves about 0.4% compared with the bank, which is $960. More importantly, she has a clear contract and a regulator to turn to if something goes wrong. She writes a one-page policy listing the brokers she may use and the checks she must make before opening an account.
Watch out
Common mistakes.
- Choosing a broker only on headline spread. Fees, execution quality, withdrawals and regulation all affect the true cost.
- Using the maximum leverage on offer. High leverage can wipe out a deposit with a small market move.
- Skipping the regulation check. Unregulated brokers are a common source of fraud.
Questions
People also ask.
How do forex brokers make money?
They earn from the spread, from commissions and sometimes from the trading losses of clients if they act as the counterparty.
What is margin?
It is the deposit a client must hold to support a leveraged position.
Can a business use a forex broker?
Yes, many companies use specialist brokers for conversions and forward contracts, provided the broker is regulated.
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