Which type of broker should you opt for?
We recommend that you read this before making your decision on opening or changing your broker.
You have many options of types of account, these are shown below initially as how your orders are processed and then the type of account with reference to taxation.
There are many different types of broker with some being a combination of more than one type. There are benefits with some of these which may effect larger traders and professional traders, whereas make less difference to smaller traders. Here we look at the options open to you.
The forex market is not operated through a single exchange but the prices quoted by most brokers do not differ significantly in normal circumstances. This does not mean that you will necessarily get the same fills however, time can be a factor, plus how your positions are filled. Some of the biggest differentials come when the market is volatile. The type of broker and the size of your trades can mean that there are some big differences here.
The market is made by first tier banks and large institutional market makers coming together with other banks and institutional traders. The closer a broker is to this the more liquidity is open to them and potentially the better the fills.
There are some brokers that provide this hub and subsequently offer liquidity to other brokers as well as banks, corporates, funds and market makers . One such that we have listed on this site is LMAX, who are classed as a exchange broker.
An advantage of being in this arena is the speed of execution and the liquidity. Spreads across all of the majors and cross pairs can be very small thus commissions are normally charged by the broker as that is mainly where they earn their money.
Technology is the key to modern finance hence many companies that started the online trading companies were predominantly technology companies. This has opened up the potential for just about any technology company to open a brokerage. Straight through processing (STP) brokers simply pass your order through to their liquidity providers (LP) . These LP’s could be another broker, a more specialized exchange broker, a bank or a market maker. The STP will have access to bid and ask prices from each of the LP’s. Their systems will opt for the best which allows them to benefit from tight spreads although with most they are variable rather than fixed.
Traders tend to opt for them as they do not benefit from their losses. They are compensated by a mark up on the spread and or a commission. As they are adding a step in the process it does slow the process down fractionally, but most traders would not notice it. The downside can be if the LP’s operate on a last look basis then this can result in a failure to fill or slippage.
There is not a great deal of difference between STP and ECN (Electronic communication Network) brokers. ECN brokers allow their clients orders to match other clients and participants orders in the ECN. Again the broker is not taking the other side of the traders orders, those that do not match are passed to their liquidity providers.
ECN brokers are preferred against STP brokers as they typically quote smaller spreads but charge a commission. However as with the STP brokers for some of the time they are only as good as their liquidity providers, thus can be subject to requotes and slippage. The benefit is that they may be able to match it in-house which technically could result in a zero spread but realistically they still charge a spread.
Market making Brokers
The final alternative is trading with a broker that makes the market. They will take the other side of the trade and balance the risk using third parties when necessary. Their model works on the fact that many traders lose money (on average 80%+) thus they can offer tight spreads and the trading costs are included. For smaller accounts this works out quite well for most of the time. They have good matching tools and many execute very fast. The downside can be when there is more volatility as they may have to go to third parties to ensure that they do not take a big hit.
They often segment their client base into an A book and B book, with the A book clients business effectively either matching with the B book or going straight through to their liquidity providers. From experience with some, there can be delays with this and the broker will retain a last look process where then can reject the quote and go for the next best.
Order Processing in summary
If you have the choice of brokers then the closer you are to an exchange the better. There is still a lack of transparency with many brokers although things are getting better.
We see this as a key aspect of those brokers that we have selected.
Account type - Forex CFD's or Spreadbetting?
There are great debates held on what is the best type of account mainly down to taxation. On that basis we look at the pros and cons accordingly.
In terms of simplicity of trading both spread betting and CFD’s are generally the easiest although modern forex platforms have been designed to make trading more straight forward. We have discussed the ease of use of the platforms on each review.
For traders in the UK and Ireland they have a slighter wider choice then traders from the rest of the world as there is an option to spread bet. The great play here is that your winnings are tax free. This is great in theory but in reality as you will see by the risk warnings on every page of this site, trading carries a high risk and up to, and maybe beyond 85% of traders lose money. Losses cannot be offset on capital gains etc in the UK.
Aside on the tax aspect the account is treated identically as a CFD or Forex account would be. The broker will be a market maker, offering you the chance to bet on the movements in the particular market. If you are a larger trader, and or successful your positions are most likely will be hedged in the real forex market with top tier banks or other liquidity providers.
Some larger traders may be drawn to the savings in tax and like a punt. Larger positions are often filled slowly and often on a manual basis which only really increases costs.
Contracts for difference are a great instrument allowing brokers to offer a much wider choice of asset classes to their clients. This means that if you are keen to trade shares with leverage along with currencies, you can do so from all one account.
One of the benefits they may been seen to have over some forex accounts is simplicity. You are able to trade a set amount per tick and it is the same across whatever currency pair you are trading. This also applies to shares, if you trade US stocks using CFD’s there are no currency costs/risks.
Any broker offering CFD’s will be acting as a market maker although some will hedge your positions using the underlying assets. The costs associated with trading are normally built into the spread which has its pros and cons.
With regards to tax, you are liable in the UK for capital gains tax. This is not a problem for many as they do not make money. However losses can be offset against gains from current of future gains. You should discuss this with an accountant/ tax specialist for your country.
This is the purest way to trade forex and is more common with Exchange, STP and ECN brokers. When trading forex you will be trading in contracts with the standard size being $100k lots. Many brokers now split the contract size down to $10K lots which suit smaller traders.
When you trade in these lots you will just need to take into account that the amount of value of each tick/pip may vary subject to your account currency and the currency pairs that you are trading. Many brokers now show you the actual value per tick/pip.
Some brokers are still very old fashioned (none of the ones listed) and will leave you with currencies you have traded in rather than converting it back to your account currency. If your broker does this you may have to ask to change it back otherwise you are effectively in a trade verses your base currency.