Choosing brokers is sometimes about commission or spread. It's not as simple as which one is cheaper but rather which is more sensible to you.
Regardless of the gains or losses obtained by individual traders, forex brokers will always find ways to gain money to keep their businesses up and running. And yes, this includes commission-free and zero-spread brokers as well. Unfortunately, not all brokers are clear and transparent when it comes to this. Some brokers may impose hidden fees to take more money from their precious customers. This is why it's highly important for traders to understand how this works and figure out whether your broker is fooling you or not.
In this article, we will dig into different methods that brokers use to gain money and help you choose between commission and spread.
How Broker Firms Make Money
Different brokers use different pricing models to make money. Generally speaking, forex brokers make money in two common ways. First, they charge spreads and/or commissions to their clients and make profits. The other way is to create a market and make money from traders' losses.
In order to understand the pricing system that the broker might be using, it's important to understand the different types of brokers. The first type is called STP (Straight Through Processing) brokers. This type of broker uses a Non-Dealing Desk model, so they only act as the intermediary between traders and liquidity providers. The moment they receive an order from a trader, they will automatically send it to another party that is providing the liquidity (usually a group of banks or interbank exchanges). Once the liquidity provider sends back a price, the broker adds a specific amount of spread on top of it and simply makes profits from the trader.
Meanwhile, brokers that make a market and trade against their own clients are called Market Maker brokers. These brokers use the Dealing Desk model, so they make their own market by quoting the buy and sell prices and providing liquidity for their clients. Basically, they take the trader's order and try to find a match to take the opposite side. If they can't find the right match, they will take the other side and practically trade against the trader. In other words, the trader's loss is the broker's gain and vice versa.
See Also: What Does a Market Maker Do Behind You?
The fact that the broker can gain profit from their clients' losses is part of the reason why Market Makers are often regarded in negative light. However, it is worth noting that many Market Maker brokers are regulated by well-known financial authorities and have no bad intentions as they intend to keep their clients. However, a market maker broker always tends to be riskier than other types of brokers so make sure to think carefully before making your decision.
When it comes to trading fees, most brokers will make you choose between spread and commission. If you choose to pay spread only, then you won't have to pay any commission but the spreads are usually higher. On the other hand, if you choose commission, then you will have to pay a fixed commission on every trade but the spreads are significantly lower.
See Also: Forex Brokers Offering Free Commissions
Understanding How Spread Works
Spread is the difference between the bid and ask prices of a specific asset. The bid price is the price that you will earn from selling a currency, whereas the ask price is the price that you need to pay for buying a currency. If you take a look at your trading platform, you'll notice that there's always a difference between the price of buying and selling assets. This difference is what we call spread.
Here's an easy example. The difference in price is the spread markup. In this case, the spread is 1.1252 – 1.1251 = 1 pip.
You only need to pay the spread once per trade. The actual amount of the spread may vary depending on the asset that you are trading. Major currency pairs that are heavily traded typically have smaller spreads, while exotic pairs have much larger spreads. Also, note that spreads can suddenly become high during important news announcements and huge market swings.
There are two types of spreads commonly found in forex brokers.
Fixed spread is the type of spread that stays the same regardless of the market condition. In other words, whether the market is extremely volatile or somewhat quiet, the spread won't be affected. This type is usually offered by market makers or Dealing Desk brokers.
The advantage of using fixed spreads is that they typically have smaller capital requirements, so it offers a cheaper alternative for traders who don't have a lot of money in their pockets for trading. It can also give you a sense of certainty because the amount rarely changes, so you can calculate the trading costs even before opening a position.
However, when it comes to the actual trading scenario, using a fixed spread can be both good and bad, depending on the situation. On one hand, fixed spread can save you from unexpectedly costly trades because the broker can't widen the spread to adjust to market conditions. But on the other hand, fixed spreads can make you miss a trade because of requotes or slippages.
Flexible or Variable Spread
As the name suggests, flexible spread is the type of spread that's constantly changing. This means that the spread will widen or tighten based on the supply and demand of the currency and the overall market volatility. This type is usually offered by Non-Dealing Desk brokers and is mostly suitable for long-term traders because their trades have less restricted timing.
Flexible spreads usually tighten during calm markets and widen when the volatility is high or the liquidity is low. This model can reduce the chance of getting requotes, but it's definitely not ideal for scalpers and news traders. Spreads can widen so much and turn the trade unprofitable in a blink of an eye.
Understanding How Commission Works
Some brokers don't mark up the spreads and instead, charge clients with a fixed amount of commission in every trade. This option is considered beneficial for traders who like to trade during news releases or periods of low liquidity. While the commissions are mostly pretty high, this system can protect traders from abnormally wide spreads during certain market conditions and minimize the chance of getting requotes and slippages.
Some brokers even go further and offer near zero or zero-spread accounts. Many traders are naturally attracted to this offer, thinking that they can reduce their trading costs by paying no spreads. However, it is important to understand that zero spread doesn't necessarily mean zero cost. Brokers with this type of account typically charge commission and require a high minimum account size, so it may not be suitable for all kinds of traders on the market.
So, Which One is Better?
The question of which is a better option between spread and commission depends on the need of the trader. Some traders may find spreads more profitable because they don't trade that often and some others may choose to pay commissions for a completely different reason.
To be able to choose the best method, it's highly important to know what type of broker you’re dealing with to figure out how they make money and how you're supposed to deal with them. If your broker is regulated, you can simply ask them as they are obliged to follow the rules imposed by the authority. However, if the broker is not regulated by a trusted authority, then you can only hope for the best because they don't need to follow any rules and they can pretty much do whatever they want with your money. That is why it's so important to make sure that your broker is regulated.