Explanation of a Forex Broker

Why You Need The Big Banks or Brokerage Houses

Forex broker checking his smart phone with double exposure of abstract business chart bars on bright city background
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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 where 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.

Key Takeaways

  • A forex broker is a link between a trader and the network of banks that have access to forex liquidity.
  • Forex brokers give you access to foreign exchange trading and leverage to trade with.
  • Before you start trading forex, make sure you educate yourself and verify that your broker is reputable.

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 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 start 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. For example, leverage of 10:1 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 five 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 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. Although it's improved dramatically, you may still run into some forex brokerages that are less-than-reputable. The National Futures Association (www.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 a U.S. authority regulates them. Regulated brokers will disclose this information on their websites.

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.