This article will help you understand dealing spreads and how forex brokers make money.
The forex market generally allows its Interbank market makers and retail forex brokers to charge their customers a dealing spread as an incentive to provide liquidity to the largely unregulated market. This dealing spread is the primary transaction cost charged to forex traders.
Because of the importance in obtaining an edge in the market, many short term or very active traders seek out brokers or market-makers which offer the most competitive dealing spreads since tight dealing spreads lower such a trader’s overall costs considerably.
The following sections describe what the dealing spread is and how it encourages market makers to provide prices and brokers to handle customer business.
What Dealing Spreads Are
Essentially, the dealing spread is the difference between the bid and offer prices in a forex quotation for a particular currency pair. The bid is where a customer can sell to the market maker, while the offer is where the customer can buy.
Typically, such dealing spreads in the forex market in the majority of the highly active currency pairs can vary anywhere from one pip to five or six pips, depending on the currency pair involved.
Although these extra pips taken out by the dealing spread can really add up for active traders or those dealing in especially large amounts, this rather minimal transaction cost compares rather well with the fees charged to trade in the stock and futures markets, for example.
Overall, the bid/offer spread usually represents the incentive for the market maker, the commission for the broker and the dealing market readily available to the forex trader.
An Incentive to Market Makers
The dealing spread represents the primary means by which forex market makers will make money in exchange for providing liquidity to the forex market.
Also, it is the way in which the professional dealer is compensated for making prices. In general, such market makers wish to deal as often as possible on both the bid and offer sides of their quote with the goal of capturing the dealing spread.
Nevertheless, during the release of important economic data or in the event of a major news announcement, dealing spreads can widen considerably. This happens as market makers protect themselves from getting unfairly taken advantage of while the new information is being discounted by the market.
Brokers Add Commissions Into Spreads
When individual traders deal forex via an online retail forex broker, the dealing spread they experience will tend to be the aggregate of a number of different market maker quotations.
Also, the spread will often incorporate the retail broker’s commission because many brokers base their forex commission structures on dealing spreads.
Often, such forex brokers will offer their retail customers a fixed spread rate or a variable spread rate which is generally wider than what they receive from their liquidity providers. Also, a broker can sell his order flow to a large market maker to provide an added incentive to handling their customer business.
Another commission option used by some brokers involves charging a straight commission per trade of perhaps a half a pip wider on either side than whatever they are receiving from their liquidity providers. This method can allow them to offer customers the possibility of even tighter dealing prices and a known commission.
How brokers profit from orders
Making Money on Stop Loss Orders
One significant way that some brokers make money is to increase the slippage on order execution. Slippage occurs when your order, usually a stop loss order, is not executed at the price at which it was placed with the broker.
For example, you may have put a stop loss order into the market to sell 100,000 Euros at 1.2500, but when 1.2500 actually traded, the forex broker filled your sell order at 1.2495 instead of at 1.2500. This fill would result in a slippage of 0.0005 or 5 pips on your order.
Nevertheless, if the broker was in fact able to execute your sell trade at 1.2500, then the 5 pip difference between that rate and the 1.2495 rate that you were filled at represents profit for the broker.
Many brokers and dealing desks routinely take a few pips in slippage out of customer stop loss orders. This is especially true if the market then traded further in that direction, thereby making the order rate more attractive than the present market rate even taking into account the slippage.
Making Money on Take Profit Orders
Although slippage is especially noticeable on stop orders since the rate changes from what a trader had left their order at, brokers and dealing desks can also make money on your take profit orders.
Generally, the way they would do this is to wait to fill your order until the market was better than the order level. They would then trade at the better level and fill you at the worse order level you had requested. If they could not trade at a better level, the broker might not even fill the order at all.
For example, consider the situation of a trader leaving a take profit order to sell 100,000 Euros at 1.2500 with their broker. When the market gets to 1.2500 bid the broker still does not fill the order. Instead, they wait until the market is 1.2505 bid to sell the 100,000 Euros of the order and fill the trader at 1.2500. The 5 pip difference is profit for the broker.
Of course, the risk of allowing this practice is that the market may trade at 1.2500, but not at 1.2505 and this would mean that your take profit order might not be executed because the broker was waiting for 1.2505 to execute it.
Selling Order Flow
Another way that forex brokers can profit from orders left by their clients is to sell their order flow to a large forex market maker. This gives the broker extra cash and also enhances the market-maker’s book, possibly resulting in orders that cancel each other out.
Furthermore, having access to significant aggregated order flows like this gives the market maker good information about where speculative traders are leaving their orders in the market. They can then trade ahead of take profit orders and aim to trigger stop loss orders in thin markets to make additional profits.
Typical Broker Commissions
Often, online brokers will charge retail forex clients a commission by tacking on to the bid ask spread anywhere from one pip to five or more pips, depending on the currency pair involved
Furthermore, the width of the bid ask spread can be fixed, where the broker establishes the spreads in advance for each currency pair they handle.
Spreads can also be variable, where the bid ask spread changes depending on the volatility and liquidity of the market in each currency pair.
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