Friday, March 5, 2010

Why Brokers Want the Best for You (Really !)

In the retail forex market people have always wondered if forex brokers actually work against them rather than with them. Traders usually have a misconceived notion that brokers want to screw around with them and take away their last penny, taking their accounts towards an inevitable wipe out. On today's post I want to explain a little bit to all traders how the broker business actually works and why brokers benefit more from helping their users than from playing tricks to make them lose money. I hope that in the end you will understand why it is not in the broker's best interest to make you lose your money and why capital loses are, in most cases, the trader's fault (of course, it is always easier to blame the broker).

So why do people think brokers play games with them ? This notion comes from the misconception that a broker which does not execute all orders directly in the market executes all orders against himself. That is, the broker loses money when the trader wins and the broker wins money when the trader loses. In such a working scheme it is obvious to think that the broker will benefit from making the trader wipe his or her account rather than from taking the spread comission which is the real business of brokers. But how does the broker business really work and why is this not the case ?

In reality, any given broker will not execute all orders on the real market because some orders are just to small. For example, if I traded 0.01 lots the broker would need to execute a 1000 USD contract on the interbank network, something which is very small and absolutely not worth the hazzle of true execution within the market. In fact, regular brokers do not execute ANY orders directly related to a trader on the real market. What they do is a simple internal balance. For example, if the broker has 10 lots in long EUR/USD positions and 12 lots in EUR/USD short positions the broker is exposed by 2 lots of long positions so the broker executes this position on the interbank market, effectively making its trading balance neutral. In reality, when you trade with any retail broker most of the time you are trading against other traders in the brokerage (they pay for your profits, they benefit from your loses) NOT against the broker.

The broker cannot simply withstand the execution of all operations against itself because this may lead to a very unhealthy market exposure for the broker and eventually will make the broker take substantial loses which are simply not acceptable. For this reason the above explained balance operations take place. Brokers execute these operations with banks in the highest possible frequency but the fact is that they are rarely executed more than once or twice every hour due to the fact that these operations cost money for the broker.

This is the reason why brokers hate scalpers because scalpers take and exit positions very quickly before they are able to balance their trading positions. Scalpers effectively make the broker assume the trade, something which brokers do NOT like. Another common complaint is that brokers issue a lot of requotes, they do this to protect themselves from the exploitation of some market inefficiencies related with off-quotes which if tradable would constitute a very profitable venture. For example you will notice on currencies like the EUR/CHF that sometimes a channel is formed on the 1 minute candles, then you see a quote appearing outside the channel, if people could buy or sell from these quotes to get back into the channel they would be able to profit almost without any stop. These quotes are "abnormal" and they are generated from random events in the market (a bank teller issues a transaction for a friend at a slightly reduced rate, for example). Therefore the broker knows these quotes are not normal and requotes traders whenever they try to use them.

Of course, any trading system which tries to exploit short movements will suffer from these restrictions done by most brokers (which also include spread widening to cover themselves from spread crossing under very low or high volumes) reason why people tend to blame the broker for the lack of effectiveness of several of these systems in live trading.

Effectively any given broker will like to have as little exposure to its clients' trades as possible and their main benefit from having a client trade is the actual collection of the spread. They do not benefit or want to trade directly against the trader because this is a risky venture, while taking the spread is risk-free. I have spoken to several people who work within brokers through the past years and I can tell you that their biggest interest is to keep you alive for as long as they can, the more trades you make, the more money they will make and the more money people make, the more money they make. As effectively, if all people make money, the money is extracted from the balance operations the broker executes with the interbank market.

So are brokers after you to screw you and make you lose your trading capital as fast as you can ? No, I find that there is simply no reason for them to do so and if they tried, they would expose themselves to a very high risk. The regular reasons why people complain about brokers such as requotes, slippage, etc are a consequence of the way in which they have to conduct business to make traders remain within a certain timeframe of execution or to avoid the exploitation of off-quote-related market inefficiencies (which are usually very short lived, they are scalping trades). I can say that I have never seen conclusive evidence of any broker doing anything to intentionally cause loses to forex traders. On the contrary I have seen efforts to preserve traders' capital a few times.

If you would like to learn about automated trading systems and how I plan to use them to achieve long term profitability in forex trading please consider buying my ebook on automated trading or joining Asirikuy to receive all ebook purchase benefits, weekly updates, check the live accounts I am running with several expert advisors and get in the road towards long term success in the forex market using automated trading systems. I hope you enjoyed the article !


Tcxmon said...


Good post since I often wonder what really goes on behind the scenes at an FCM.

I wonder if you can elaborate on the difference between a 'dealing desk' execution and and a 'no dealing desk' execution and if you have any evidence that one is any better than the other.

Also, I would appreciate if you know anything about 'ECN' brokers and if its possible to run Metatrader through an ECN type broker.


rogermh said...

I would also like to know the difference between "dealing desks" and "non-dealing desks". I have read that dealing desks take the opposite side of your trade and thus it is better to use a broker who does not have a dealing desk.

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