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Forex brokers offer retail investors in the U.K. speed, convenience and cost savings for global forex trades. Here’s what you need to know about how forex brokers work, and why you might want to use one.
A forex broker provides a platform from which traders can trade in the forex markets. This service does not come free, but forex brokers do not charge trading fees or commissions. Instead, forex brokers make profit from the spread, which is the difference between the ask (the price traders buy at) and the bid (the price traders sell at).
Additionally, some forex brokers may also charge admin fees, including for accessing exotic currency pairs, expert advice and recommendations, or for account withdrawals. There are also charges if you choose to trade on margin.
All these can be quite obscure to those new to forex trading, which makes it important to understand how forex brokers work and how to choose one.
Get a headstart with this article, which explains all you need to know about picking the right forex broker for you.
What is forex trading?
Forex is short for ‘foreign exchange’, and the forex market refers to the global market in which sovereign currencies are exchanged for one another.
It is the largest and most liquid asset market in the world, owing to the pervasive reach for trade, commerce and finance; currency trading volume reached US$ 6 trillion per day in 2022, larger than the global stock or bonds markets. [1]
While some of this massive daily trading volume comes from exchanging currency for tourism and cross-border commerce, a healthy portion is generated through forex trading.
Instead of satisfying a practical need, forex trading is performed solely for the aim of making profit from the price fluctuation of different currencies, relative to one another. Currencies strengthen and weaken against each other, and forex traders can generate profits if they manage to make the right trades at the right time.
This can be easier said than done, owing to the dynamic, fast-moving nature of the forex market, which is sensitive to global events and macroeconomic changes.This was acutely demonstrated during the 2015 Swiss Franc collapse, which saw massive losses inflicted on retail forex investors and forex brokerages around the world. [2]
Forex brokers explained
As mentioned earlier, forex traders can use a forex broker to speculate on the direction of currencies, by making trades revolving around currency pairs.
Through a forex broker, traders open a trade by buying a currency pair, and close the trade by selling the same pair. Using the USD/JPY currency pair as an example, buying the pair is the same as exchanging U.S. Dollars for Japanese Yen. When selling the pair, Japanese Yen is used to exchange for U.S. Dollars.
If the exchange rate is higher when the trader closes the trade (sells the pair), the trader makes a profit. But, if the exchange rate is lower when the trade is closed, the trader makes a loss.
However, a rise in the exchange rate isn’t the only path to profitability for forex traders. Forex brokers take long and short sale positions on currency pairs. Hence, if the exchange rate falls, the trader makes a profit if they had opened a short position instead of a long one.
Forex brokers routinely offer margin trades, which essentially allows you to amplify your trading outcomes even if you have a low starting capital. Note that when trading on margin, both profits and losses will be magnified, heightening the risk of investing.
Finally, forex brokers may be classified into one of two main categories, as shown in the following table.
| Dealing desk | Also known as market makers, dealing desk brokers set a fixed spread for currency trades. They mainly serve institutional investors due to their ability to create markets to trade within. |
| No dealing desk | This category of brokers track currency prices from banks and financial institutions and pass on the most favourable ones to traders. They mainly serve individual retail traders, who may otherwise face difficulty in accessing the interbank system and make trades on their own. |
What can you trade with a forex broker?
A forex broker offers forex trading in currency pairs denominated in currencies of the G10 nations, which include:
- U.S. Dollar (USD)
- Euro (EUR)
- Sterling Pound (GBP)
- Japanese Yen (JPY)
- Australian Dollar (AUD)
- New Zealand Dollar (NZD)
- Canadian Dollar (CAD)
- Swiss franc (CHF)
- Chinese Renminbi (CNY)
- Hong Kong Dollar (HKD)
These 10 major currencies and their pairs aren’t the only currencies offered at forex brokers. Some forex brokers may offer minor currencies or currencies from developing economies.
As such, currency pairs may be grouped according to the currencies they contain. Major currency pairs are made up of the most commonly traded currency pairs in the world.
Pairs that do not include the U.S. Dollar are termed minor currency pairs, or cross-currency pairs.
Meanwhile exotic currency pairs include a currency from a major economy, and one from a developing economy.
You may look through the website of a forex broker to find out which forex currency pairs they offer.
Why you may want to trade using a forex broker
The main reason to trade forex using a forex broker is that doing so is the most time-efficient and cost effective option for individual retail traders.
This is because only licensed forex brokers have access to currency buy/sell operations, which are at the heart of forex trades. These operations and the digital platforms they are hosted on require high fees that are impractical for the average trader to foot on their own.
There are also other impediments to forex trades attempted without a forex broker, as detailed in the next section.
Limitations of trading without a forex broker
Forex traders can attempt to make forex trades using peer-to-peer currency transfer platforms. However, these platforms are designed to help consumers transfer money across borders, and do not offer a matching service between forex traders.
Additionally, there may be limited currencies available, owing to regulatory constraints or a lack of liquidity. In the latter, peer-to-peer currency transfer platforms may step in to provide the necessary liquidity for the transfer to go through, but charge higher fees in return.
Also, peer-to-peer currency transfer platforms may charge higher spreads than a forex broker, which means less profitable trades.
Another method would be to make use of a multi-currency bank account and transfer money between different currencies and attempt to accrue gains over several transfers.
Besides being time consuming and having to keep a close eye on the currencies you want to trade, you may also incur bank fees, or be stymied by transfer limits. It is also likely that you will need a substantial starting principal in order to see any meaningful progress, as you will not be able to use margin or leverage when transferring funds within a multi-currency account.
How to get started with a forex broker
Now that you understand how forex brokers work, and the potential limitations of trading without one, let’s take a look at how to get started with a forex broker.
Getting started with a forex broker is a relatively simple process.
Firstly, you should study and evaluate the forex brokerage you want to use. Check to see if it offers the currency pairs you want, and what types of trades are available.
You should also check the spreads, fees and charges on the forex broker – these have the potential to affect your trading outcomes.
Another thing to check is the type of educational and learning materials offered, as well as the degree of customer service and support provided to customers.
Once you have decided upon the forex brokerage you want to use, the next step is sign up for an account. You can simply follow the instructions on the website to do so.
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References:
[1] Investopedia, How to Choose a Forex Broker: What You Need to Know, https://www.investopedia.com/investing/how-choose-forex-broker-everything-you-need-know/
[2] Reuters, Factbox: Swiss franc shock takes toll on retail FX brokers, https://www.reuters.com/article/us-swiss-franc-brokers-factbox-idUKKBN0KP1EQ20150117
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