How Do Forex Brokers Make Money?

Posted by Nick Niesen on October 29th, 2010

It is one of the most talked-about advantages of trading on the Forex?the commission-free trades! Unfortunately, while we would all like to think that Forex brokers are just out there executing trades for the fun of it, the simple truth is that everyone needs to make money?even the brokers. While they may not charge a traditional commission, brokers on the Forex still make their money whenever trades take place. Brokers actually are compensated in a number of ways, including:

?Buying/Selling Currencies
?Earned interest on deposited funds
?Converting and holding currencies
?Rollover fees

It is in the buying and selling of currencies that brokers make the majority of their money. They make this money in something known as the ?spread?, or the difference between the asking and bidding price of the currency pair. The ?ask? is the price a retail Forex trader would pay for a position. The ?bid? price refers to the amount that an investor could then sell the position at.

The smallest unit of measure in Forex trading is known as a pip and it is equal to .0001 (except for the Japanese Yen, which is .01). The difference between the ask and bid price is typically only 3 or 4 pips and this is what the broker makes when buying and selling currencies.

A broker is actually a middleman and never actually charges anyone directly. Instead, a broker purchases a position from a larger investment institution and then sells it to the retail Forex trader while pocketing the difference between the two amounts. For instance, a broker might set the ?ask? price at 1.250 and the ?bid? price at 1.246. If the investor were to sell the position immediately, then the most they could sell it for would be the ?bid? price of 1.246?or a loss of 4 pips. Since the typical Forex transaction is conducted in $100,000 lots, that means that the broker made $40 in that currency exchange.

The spread will vary depending on the broker and the currencies being traded. Typically, the spread averages between 3-5 pips. Unfortunately, brokers are necessary tools in the Forex trading game if for no other reason than the sheer size of the transactions. There is approximately 1.8 trillion dollars exchanging hands on the Forex every day and these transactions are conducted in $100,000 ?lots? (there are also $10,000 mini-lots and even micro-lots). Thus, it is typical for Forex transactions to be highly leveraged with most traders only putting up $1,000 (or 1/100) in capital.

Forex brokers will tend to be partners or somehow associated with investment banks and similar institutions. These ?backers? actually guarantee the loans used to leverage Forex trades?and without them?none of us could trade on the currencies markets unless we were willing to risk more than the 1% demanded by most brokers.

Yes, the brokers do make money when investors trade on the Forex but they do provide a genuine service. Just be careful to avoid trading too often because although the pips are small?they can disappear quickly especially when investors try to compensate for a loss by turning around and investing before doing their homework. Therefore, be wary of any Forex broker that advocates any form of ?day trading? or the like?it?s a very, very dangerous strategy to use in the most volatile and fluid market the world has ever known!