How to select a Forex Broker

Usually most traders focus most of their efforts on the search for a good system or EA to get optimal returns on their investment.

What most traders don’t realize however, is that a good broker can have a large impact on those expected returns. And as you’ll find out in this article, spending time on selecting a good broker can certainly pay off. Big time.

Since 2007 there has been an explosion in the number of forex brokers available to the retail trader. While there were only a few to choose from four or five years ago now the number would be in the hundreds, if not higher. While we are spoiled for choice, choosing the right broker can still be daunting task.

When comparing brokers, traders tend to base their primary ranking on the following criteria:

  • Spreads
  • Commission
  • Type of broker: Dealing Desk, Straight Through Processing, ECN etc
  • Regulation
  • Customer service
  • Tick Speed

No surprise: the spread tops the list, as it’s a quick and easy way to compare brokers. However, before diving into the nitty gritty of how spread and pricefeed can influence your trading results, let’s start with dividing brokers into two buckets first: Dealing Desk/Market Maker brokers and the Non-Dealing Desk brokers. Because that’s where a lot of trouble starts.

Dealing Desk/Market Making Brokers

This type of brokerage is probably the first to come to market. These brokerage houses trade on their own equity (they have little or no access to liquidity providers) and “make the market”. This usually means they take the opposite of your trade on their own account.

For example: the “Dealer” receives an order from you to go long, and if he accepts your order he might take the short position or match that with another order from another client who wants to go short at that time (so their order book is ‘balanced’ and their own exposure is now reduced).

One of the main tasks of the Dealer is to ensure the broker maximizes profits and reduces its own exposure to a minimum. To maximize profits and reduce his exposure, the Dealer has access to numerous tools to manage his business and balance his orderbook.

In the screenshot above, you’ll see just one example of how the Dealer can actually ‘manipulate’ your order. The Dealer can choose to delay your order, reject it, or issue a requote and offer you a different price. Note how they can increase price and spread at free will.

The business model of these types of brokers is simple: maximize returns on spread, delaying orders, filling orders at different price requests (requotes) to ensure the odds are even more against you. Moreover, when the balance in the orderbook allows, they can initiate stophunts by moving price up or down in quick spikes to trigger your stops.

Below you’ll find screenshots from the Metatrader4 Market Maker Handbook, showing the Quote tool.

dealer_02.png

As you can see, the broker (Dealer) can adjust the spreads on a global level for each pair and add the spread to the quotation flow in the pricefeed. This is called “mark-up on the bid”, and will alter the actual pricefeed and thus impact your EA results.

Can this get any worse?

Unfortunately, yes. For example, have a look at another tool brokers have at their disposal, the Virtual Dealer Plugin, developed by Metaquotes, the same developers that gave you Metatrader4.

With this tool, forex brokers can stack the odds even more against you. They can manually or automatically delay execution, slip your trades, trigger stops and stopouts, and even –silentlly and temporarily (!) – adjust your leverage to enforce a margin call.

But don’t take our word for it, have a look at the screenshots below:

virtualdealer_02.png

virtualdealer_03.png

If you’re interested in reading more about this, the complete PDF can be downloaded here.

So how do we know what games brokers are playing?

Well, there is hope. Have a look at this video:


The guys from 4xTrader.net seem to have developed a great tool called 4xSentinel to detect suspicious broker activity. We’re testing it at the moment on our live accounts. If you want to know more about this tool, have a look at their website: www.4xtrader.net

Non-Dealing Desk Brokers

These brokers play a different role. They basically ‘pass on orders’ to their liquidity providers. Non-Dealing Desk (NDD) brokers are often also called Straight-through Processing (STP) or Electronic Communication Network (ECN) brokers. More info on what the differences are and how they operate can be found here:

http://en.wikipedia.org/wiki/MT4_ECN_Bridge

http://en.wikipedia.org/wiki/Electronic_Communication_Network

http://en.wikipedia.org/wiki/Foreign_exchange_market (also shows major liquidity providers)

The business model of these brokers is relatively simple: they receive commission on every order placed from the trader and might receive commission from their liquidity providers as well, based on volume. Alternatively, they can ‘pad the spread’ to make money.

The liquidity providers these brokers rely on are usually large banks, and most of the NDD brokers are connected to the interbank feed via a bridge, allowing them to put every order straight through to the interbank network.

Since they don’t manage their own orderbook, these brokers tend to be more honest for the trader, as they don’t have to manipulate orders and/or take the opposite side of our trade to make money. However, they can still ‘influence’ the trade by marking up the spread and delaying orders. Also, if they don’t have access to good liquidity, your orders might be filled at a worse price (slippage).

Please do realize that NDD brokers who advertise “no commission charges” are the ones you want to avoid, as they get income from padding the spread using the tools described above, and thus influence the pricefeed. Now, some of them might claim they get their revenues from their liquidity providers based on transaction volume, so check with them first.

We feel the true ECN broker charging a commission is the one type of broker that has the least incentive to ‘mess with your trading’.

Spread is the Word

Comparing spreads on the currencies you most often trade is a good first way to draw up a short list of brokers.

The best site with a comparative spread table is:

http://www.myfxbook.com/forex-broker-spreads

For the two pairs our EA trades you should only accept a broker if it offers spreads that are less than 2.0 pips for the EURUSD and 3.0 for the AUDUSD on average.

Not only are you doing yourself a disservice by paying more, but at higher spreads, something else comes into play: a change in the pricefeed. And while paying a bit more spread may seem acceptable, the alteration of pricefeed may actually negatively impact your trading results a lot more than you think. For example, EAs might be coded to trigger a signal at the Ask price or to close a long trade at Ask. Now, the larger your spread, the more risk you run of missing the entry signal or fail to close this trade successfully.

The Impact of Tick Speed and Price Feed on your Trading Results

Probably the most undervalued feature when comparing brokers is the pricefeed. We’ve all heard about it and mentioned it int his article already a few times. But what is it and how does it influence the results?

Well, as we’ve seen above, some brokers have their ‘own’ pricefeeds (Dealers with own orderbook) while others rely on pricefeeds from their liquidity providers.

The concept behind the pricefeed is actually very simple: It describes when and how the bars are formed on your chart. For every tick that comes in, a new price is established and a new part of the bar is drawn. Since every tick represents a trade that took place, the more ticks you receive from your broker, the more realistic the pricefeed. This means your broker has access to lots of liquidity and prices probably reflect the current market situation accurately.

How can differences in pricefeed impact our trading?

Have a look at the screenshots below.

pricefeed_diff_trades.png

Note: On both brokers, TP was hit and all positions were closed in a nice total net profit. However, the first broker (left) took just longer to reach TP.

This is just one example of how pricefeeds that may appear totally similar to the eye, can impact results rather drastically when trading.

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