Explanation of a Forex Broker
Why You Need The Big Banks or Brokerage Houses
A forex broker works as an intermediary between you and the interbank system. If you don't know what the interbank is, it's a term that refers to networks of banks that trade with each other.
Typically a Forex broker will offer you a price from the banks of which they have lines of credit and access to forex liquidity. Many forex brokers use multiple banks for pricing, and they'll offer you the best one available.
Opening a Forex Trading Account
To get an account with a forex broker, it's a bit like opening a bank account. It requires paperwork and steps such as identity verification. The whole process takes a few days.
However, if you're just looking to test the waters, forex brokers offer demo accounts for which you only need to provide minimal information to open. A demo or practice account allows you to get set up and get some practice trading until you're ready to get started trading with real money.
Forex Brokers Offer You Leverage
The ability to use forex leverage comes with every account, and it varies in an amount anywhere from 10:1 to 100:1. A 10:1 leverage means that for every $1 in your account, you have $10 to trade.
Leverage is both good and bad as you can make exponential profits, but you can also suffer from mounting losses. The law requires forex brokers to disclose this, and they typically do in the fine print. New traders usually get excited and blow their accounts out quickly if they jump in too fast.
You'll Have Two Balances
When you're working and trading with a forex broker, there are two balances shown for your account. One balance is your actual balance, not including your open trades. Your other balance is the balance that you would have if you closed all your trades. The second balance is called your net balance.
The Bid-Ask Spread
When you open a forex trade with a broker, they pass it through to the market for you. In the process of this, they offer you a price for the currency pair that is slightly different than the price they can get.
You'll see it shown in quote form as EUR/USD 1.3600/1.3605, for example, where the first number is what the broker will give you if you want to sell the currency pair, and the second number shows what the broker will charge if you want to buy the pair. The difference between .0005, or 5 pips, is the broker's commission. The spread may widen or narrow depending on trading supply and demand.
The bid/ask difference charge is called collecting the spread. The spread or commission of sorts is mostly transparent to trading from the trader's point of view. However, you always have to keep in mind that the beauty of the spread from the broker's point of view is that it's taken from your leveraged trade size, not your account balance size.
Education to Learn Forex Trading
Forex is a relatively new arena for many investors. News that affects a stock price may have a radically different effect on the price of a currency. Also, learning how to price currencies and invest in them in a relative environment is often uncomfortable territory when a prospective investor first comes into forex.
To battle the lack of knowledge that many have due to the uniqueness of the forex market, many brokers have set up divisions dedicated to education and research to help traders get up to speed and informed on a day-to-day basis. A popular destination for many traders is the website DailyFX.
Verifying a Broker's Reputation
Forex brokers exist to make it easier for you to connect with the banks out there that are buying and selling currencies. They have a set of rules that they have to follow and certain processes that are required.
However, for many years, the forex industry was not regulated, and although it's improved dramatically, you may still run into some forex brokerages that are less-than-reputable. The National Futures Association (NFA.futures.org) follows forex brokers and can help you verify a broker's reputation.
When choosing a broker to work with, check first to see if they're regulated by a U.S. authority. Regulated brokers will disclose this information on their website.
The Balance does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.