Many beginning Forex traders wonder how the Forex brokers earn their money from the common traders if they are not casinos. Understanding the basic principles of the brokerage economics will help traders to distinguish real Forex brokers from the bucket shop scams and the honest companies from the unethical ones. Here is the list of the most common ways for the FX broker to earn money:
- Currency pair spreads. The largest source of income for the Forex brokers is spread, which is the difference between the Bid and Ask rates. A broker has access to lower spreads and adds mark-up to the spreads before passing the quotes to traders. This way, a company can earn the money that traders lose on the added spread.
- Leverage. Spreads on small positions would be too low to be a significant income source for brokers. So, many brokers offer high leverage. Of course, it is a great tool for multiplying your trading volume — it increases both your profits and losses. However, trading bigger lots that become available with 1:100 leverage, a broker earns 100 times more on spreads than it would earn without such a leverage.
- Overnight swap spreads. Brokers pay the overnight swaps to the trader if the difference between the interest rates in a currency pair is positive in the trader's position and get paid from the trader's account if that difference is negative. But these payments are not symmetrical, and they are biased so that a Forex broker would always get an advantage. When someone is selling 1 lot of EUR/USD and another trader is buying the same amount of the same currency pair, the second trader is earning money on overnight swaps, but the first one is losing the amount that is big enough both to compensate the second one's earnings and to "feed" the broker.
- Payment processing commission. Online Forex brokers rarely charge commission per trade (except Islamic accounts) and often advertise that as a feature. However, some brokers charge payment processing fees — they are deducted only when you deposit or withdraw money and usually are quite small and fixed in currency units, not percentage points. Of course, such commissions are too small to form a significant part of the broker's profit, but they are enough to compensate at least a part of the broker's expenses.
- Trading against the trader. The most despised and unethical way a Forex broker can make money is to trade against its customers. And that is the most profitable way too. Avoid brokers that earn when you lose. If the spreads are too low, the leverage is insignificant, the overnight swaps are fair and there are no commissions (for payment processing and trading), then the broker is certainly trading against you to make money.