An Introduction to Forex: Part 2 [Guest Post]

In the first part of our Introduction to Forex we talked about basic concepts and characteristics of Forex trading. In this part the focus is on the different types of Forex brokers. This should give you a clearer picture of how the Forex machine works, and how to select the right broker.

There are three main types of Forex brokers out there, namely Market Maker brokers, Electronic Communications Network (ECN) brokers and Straight Through Processing (STP) brokers. Each type operates and makes money in a different way, and it is important to know the difference before deciding which one to use.

Market Maker Brokers

Market Maker brokers are the most common. They are named Market Makers because they essentially “make” the market for their customers – they buy when a trader wants to sell and they sell when a trader wants to buy. Using a Market Maker broker, you will never see the real market quotes, because all your trades will be routed via the broker’s dealing desk. These brokers make money in two different ways. The first way is by quoting fixed spreads (the difference between buy and sell price). The second way is by hedging against their clients’ trades. This means the broker makes money every time you make a loss. Ridiculous, right?

The only real benefits of using a Market Maker broker are the low amount of funds required in order to open an account, and user-friendly trading platforms. The low amount required is mostly due to the high leverage offered, so you should put that into consideration before deciding to invest.

Electronic Communications Network Brokers

ECN brokers provide direct market access. That means you get access to the market where all of the players (i.e. banks, financial institutions, and individual traders) trade against each other in real-time. The price displayed by the broker is the actual inter-bank rate, and the spread is variable – sometimes the buy price can even equal the sell price. All of the placed orders are matched between the participating parties in real-time, and there is no dealing desk routing. Simply put, you gain access to the true Forex market. These brokers don’t make money by setting a spread, but rather by charging a commission on every trade executed. The height of the commission depends on the broker and on the amount traded.

The benefits of using an ECN broker are quite obvious. First of all, there can be nospread/price manipulation by the broker, since the price is quoted directly from the inter-bank market. Next, the spread is variable and that can be used to the trader’s advantage. Last but not least, your broker is not trading against you, like the evil Market Makers do. The only two flipsides worth mentioning are the high amount of funds needed in order to open an account, and a not-so-user-friendly platform.

Straight Through Processing Brokers

STP brokers are a sort of a hybrid between Market Makers and ECNs(but not really). They don’t route the orders via a dealing desk, meaning they send them directly to the liquidity providers – banks, for example.Traders gain access to real-time market quotes, and can execute trades without the intervention of dealers.The brokers make money not by charging commissions, but by adding markups to the spread.

The main benefit of using STP brokers lies in the bypass of dealer desks, which means the broker won’t profit when you make a loss – how decent of them. That being said, STPs still don’t grant the trader direct inter-bank access, which puts them at a disadvantage when compared to ECNs.

Which One Is Best?

So which one to choose? If you have enough money you are willing to invest, and don’t mind the increased complexity of their trading platforms, ECN brokers are definitely the way to go. They are superior to STP and Market Makers in almost every way, making them the right choice for anyone who wants to get serious about trading.

The above article is written by iMoney. Reproduced with permissions. All rights reserved.

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1. An Introduction to Forex [Guest Post]

An Introduction to Forex [Guest Post]

Forex trading has become very popular in the last couple of years – pretty sure most of you have seen a Forex ad at some point while you were surfing the internet. But what exactly is Forex and how does it work? Forex is short for Foreign Exchange, or in other words, currency trading. It has been around on an inter-bank level for a long time but recent developments in technology and online trading platforms made it possible for every individual to give it a shot. It is the world’s largest financial market with a daily turnover in excess of 3 trillion USD and a very high level of liquidity. It is also open 24/5. This would make it a very attractive market to trade in right? While this might be true, it is important to know how Forex trading works in order to determine if it matches your investor personality. This article will explain some of the main principles that you need to consider.

Long and Short Positions

Having a long position is a commonality in all the financial markets. It means you have bought a stock, for example, and you are waiting for its price to appreciate. This is exactly the same in the Forex market. Having a short position, on the other hand, is a feature much more common in Forex trading than in other financial markets. It means that you have sold a currency pair you do not own and are anticipating the price to depreciate. At a certain point you then buy the currency pair back (this is called “covering”) at a lower price (making a profit) or at a higher price (making a loss). This might seem a bit confusing but it is a really simple principle. When you go short the broker basically lends the currency pair to you and when you buy it back, you return it. That’s all there is to it.

Leverage

One of the most important characteristics of Forex trading is leverage. Leverage simply means that you are not required to put up a full amount in order to control a position – you only need a margin amount. To give an example, if leverage is 1:100 (this is the leverage most commonly used in FX trading) you would only need $1000 to control a position worth $100,000. That means you get all the risks and benefits of holding a $100,000 position – if the price rises to $101,000 (1%), you have effectively made a 100% profit on your $1000 trade, assuming your position was long.

The important thing to remember here is that leverage is a two sided blade. It amplifies your gains and it also amplifies your losses. If the price dropped to $99,000 (1%) you would lose that $1000 you initiated your trade with. Additionally, if you didn’t have any funds in excess to that $1000 on your trading account, your position would automatically be closed by your broker. You always need to maintain a certain margin of the position value on your trading account (determined by the broker) in order to avoid automatic closing.

High Frequency of Trading

Another important aspect of Forex trading is the frequency and duration of trades. When someone says they are a long term trader in the stock market, they usually mean they are holding shares for years. When someone is a long term trader in Forex, they hold their position for a couple of weeks at most. The shortest trades in the Forex market can only last milliseconds. Those trades are programmed to have automatic execution and are done tens (or even hundreds) of times per day. This higher frequency of trading makes it more exciting, but it also requires you to invest more time in developing your strategy. If you are the kind of investor who prefers to keep his position open for long periods of time, Forex might not be the optimal choice.

Liquidity

Earlier I mentioned that the Forex market was open 24/5. This means you can trade Monday-Friday all day and all night. However, you need to realize that different currency pairs have different liquidity levels at different times. For example, the most liquid currency pair, EUR/USD, will have the most liquidity when US and European markets are open, so it makes sense to trade in that time slot. On the other hand, USD/SGD will see most of the trades executed when Singapore and US markets are open.

*The above article is contributed and written by iMoney Singapore

Read Part 2 here.

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