Forex brokers make money by charging a commission or a spread on each trade that their clients make. They can make money through the difference between the bid and ask prices known as spread, charging a commission on each trade, marking up the spread, earning interest on trades, and hedging their clients’ trades against the interbank market. Understanding the fee structures is important for traders when choosing a broker.
Spread
Forex brokers make money through the difference between the bid and ask prices, which is known as the spread. The spread is essentially a commission that the broker charges for executing trades on behalf of their clients.
Example
Let’s say the bid price for the USD/CHF currency pair is 0.9900 and the ask price is 0.9905. This means that the spread is 5 pips.
If you buy 1 lot of USD/CHF at the ask price of 0.9905, the broker would execute the trade and charge you the spread as their commission. The total cost of your trade would be:
- Buy price: 1 lot of USD/CHF at 0.9905 = $99,050
- Spread: 5 pips x $10 (1 lot x 100,000 units x 0.0005)
- Total cost: $50
In this example, the broker would earn $50 from the spread as their commission for executing your trade. This is a common way for forex brokers to make money, as spreads are a transparent and straightforward way to charge clients for their services.
Commission
Some Forex brokers charge a commission to generate revenue on the trades you execute.
Example
Let’s say you place a trade for 1 lot of the USD/CAD currency pair at a market price of 1.2500 with your forex broker. The broker charges a commission of $7 per lot for your trade.
In this case, the total cost of your trade would be the sum of the commission and the spread, which is the difference between the bid and ask prices. If the spread for the USD/CAD currency pair is 2 pips, your total cost would be:
- Commission: $7
- Spread: 2 pips x $10 (1 lot x 100,000 units x 0.0002)
- Total cost: $27
In this example, the broker would make a profit of $7 on your trade through the commission. This is a common way for forex brokers to earn revenue, as commissions are a transparent and straightforward way to charge clients for their services.
It’s important to note that the commission structure may vary between brokers, and some brokers may charge different commissions for different currency pairs or types of trades. Some brokers may also offer commission-free trading but make up for this by widening the spread or charging other fees. As a result, you should always carefully review the broker’s fee structure before opening an account.
Markup
Some Forex brokers, specially market maker brokers, make money by marking up the spread.
Example
Let’s say the bid price for the AUD/USD currency pair is 0.7700 and the ask price is 0.7702. This means that the spread is 2 pips. If you buy 1 lot of AUD/USD at the ask price of 0.7702, the broker may mark up the spread to earn a profit. Let’s say the broker marks up the spread by 1 pip, making it 3 pips.
The total cost of your trade would then be:
- Buy price: 1 lot of AUD/USD at 0.7702 = $77,020
- Spread: 3 pips x $10 (1 lot x 100,000 units x 0.0003)
- Total cost: $30
In this example, the broker would earn $30 from the marked up spread as their commission for executing your trade. This is a common way for market maker brokers to make money, as they have the ability to set their own spreads and markup the prices in order to earn a profit.
Interest
Forex brokers may also make money through the interest earned on trades. This occurs when a trader holds a position overnight, and the broker charges or pays interest on the position depending on the currency pair’s interest rate differential.
Example
Let’s say you buy the EUR/USD currency pair and hold the position overnight. The interest rate in the Eurozone is currently 0.05%, while the interest rate in the United States is 0.25%.Because you’re long the EUR/USD, you’re effectively borrowing USD to buy EUR. So, you’ll be charged interest on the USD you’re borrowing and earn interest on the EUR you’re holding.
Assuming you bought 100,000 EUR/USD at 1.2200, your position is worth $122,000. If you hold the position overnight, your broker may charge you or credit you with interest based on the interest rate differential between the two currencies.
In this case, the interest rate differential is 0.25% – 0.05% = 0.20%. Since you’re long the EUR/USD, you’ll earn interest on the EUR and pay interest on the USD.
If your broker charges a 0.5% annualized interest rate on the USD and pays a 0.1% annualized interest rate on the EUR, you would earn:
(100,000 * 1.1%) / 360 = $3.06 in interest per day
You would also pay:
(122,000 * 0.5%) / 360 = $1.69 in interest per day
So, in this scenario, you would earn a net daily interest rate of $1.37. Note that the actual interest rates and charges may vary depending on the broker, currency pair, and market conditions.
Hedging
Some brokers also make money by hedging their clients’ trades against the interbank market. This means that they take the opposite position of their clients’ trades in the market.
Example
Let’s say that you place a buy order for 1 lot of the USD/JPY currency pair at a market price of 105.00 with your forex broker. The broker receives the order and hedges the trade by selling 1 lot of USD/JPY in the interbank market. This means that the broker is taking the opposite position of your trade.
If the price of USD/JPY moves in your favor, the broker will make a loss on the trade, but you will make a profit. However, if the market goes against you, the broker will make a profit on the trade, offsetting your losses.
For example, if the price of USD/JPY falls to 104.00, you will lose $1,000 (1 lot x 100,000 units x 1 pip). At the same time, the broker will make a profit of $1,000 on the hedged trade in the interbank market, offsetting your losses.
By hedging your trade, the broker is able to make a profit regardless of which way the market moves. This allows the broker to earn a commission on your trade while minimizing their own risk exposure. However, it’s important to note that not all forex brokers hedge their clients’ trades in this way, and there are many reputable brokers who do not engage in this type of behavior.
Trading Against Clients
There are some cases where a Forex broker may take the opposite position of their client’s trades, effectively betting against them. This is known as a dealing desk or market maker model. In this model, the broker profits when their clients lose money.
Example
Let’s say that you place a buy order for the GBP/USD currency pair at a market price of 1.4000. The broker receives the order and is obligated to execute it at the best available price. However, the broker may decide to fill the order at a higher price, say 1.4010, and keep the difference as profit.
If the price of the GBP/USD currency pair moves in your favor, the broker may continue to hold the position, hoping that you will eventually close the position at a loss. Alternatively, the broker may take an opposite position in the market, effectively betting against you. This allows the broker to profit when you lose money.
In both cases, the broker is trading against you by taking actions that work against your best interests. This is generally viewed as an unethical business practice and is not legal in some jurisdictions. However, it’s important to note that not all forex brokers engage in this type of behavior, and there are many reputable brokers who prioritize their clients’ interests.
Other Fees Forex Brokers May Charge
Forex brokers may also charge other fees, such as account maintenance fees, withdrawal fees, or inactivity fees. These fees can vary widely depending on the broker and the services they offer, and may include the following
Account Inactivity fees
Some brokers may charge a fee if the account has been inactive for a certain period of time. This is to cover the costs of maintaining the account.
Deposit and withdrawal fees
Some brokers may charge a fee for deposits or withdrawals made using certain payment methods, such as credit cards or wire transfers.
Overnight Financing Fees
Also known as “rollover” fees, these are charges that are incurred when a trade is held overnight. These fees are based on the interest rate differential between the two currencies being traded.
Platform fees
Some brokers may charge a fee for using their trading platform. This can be a monthly or annual fee, or a fee charged per trade.
Data fees
Some brokers may charge for access to market data or news feeds, particularly if the data is real-time or premium in nature.
It’s important to note that not all brokers charge these fees, and some may offer fee waivers or reduced fees for high-volume traders. As a result, it’s important to carefully review the broker’s fee structure and compare it to other brokers before opening an account. Additionally, be sure to read the fine print and ask questions to ensure that you fully understand any fees that may apply.
Conclusion
It’s important to note that not all Forex brokers use the same methods to make money and some may use a combination of methods. Therefore, it’s crucial to understand the different ways brokers make money and to choose a broker that is transparent about their business model.