With the relatively low cost of trading, you may be wondering how forex trading brokers can actually turn a profit. The truth is they make money the same way any broker makes a profit: They match buyers with sellers and then take a piece out of the middle.
An online forex broker that is a market maker establishes two prices for a given currency pair, a bid price and an ask price. There is always a slight difference in the two prices. The difference between the bid price and the ask price is known as the spread. This is where foreign exchange brokers will make money. They buy the currency from you ask the ask price, which is a set amount below the price another investor will buy from them at the bid price. Because the forex market is so liquid, the spread is much lower than it is in other financial markets. The transaction costs are also relatively low for market makers, lowering the spread.
(There are some cases in which a market maker foreign exchange broker may not be able to find a liquidity provider to take the other end of a trade and decide to take the other end of the trade himself and thus create a situation where the trader’s gain is the broker’s loss and vice versa.)
The trickiest part about being a broker is finding the point where they have equal bets on both sides of a currency. The constantly adjusting price is the effort of the market maker to find a price where they can find equal numbers of buyers and sellers for a given currency pair. The science isn’t perfect though and sometimes the market makers do lose money on trades. They make up for it with the sheer volume of trades that they make, racking up the spread fees over hundreds of thousands of trades a day.
Forex brokers do not make money based on market movements. In fact, they try to minimize the effects of the market on their profits!
Less Savory Profit Techniques
While this is the main way that most foreign exchange brokers make money, there are also some more unsavory methods that less reputable brokers use to make some extra cash. Watch out for these signs because they’re an indication you’re dealing with a broker that is trying to take your money in any way possible.
The main way this is done is through slippage. Slippage is the difference in price between the stop loss order that you set to sell your position in a currency and the price you actually get. You should be able to hit the price more often than not, except in very volatile markets. If you notice that your orders are subject to excessive slippage however, the broker may be selling at the stop loss point and then giving you a lower price for your currency trade. This results in a profit for the broker.
Large foreign exchange brokers mainly profit through the use of the bid/ask spread. They simply aim to match buyers with sellers by finding an agreeable price for both and take a cut out of the middle. For smaller forex brokers there are also other ways to make a profit involving the spread or selling their actual orders. Just be careful with which brokers you choose because some try to make money in more unsavory ways!