Yesterday I was in Brisbane presenting to a group of forex traders from around Australia, some of whom had been my former students a number of years ago and are now trading to make money in a full time capacity. On the list of the key topics that I covered in my round table was interbank liquidity and price creation, of course a number of the skilled fx traders in the audience knew what I was talking about but it was astounding to see that allot of forex traders still don’t realise just how currencies are priced. In order to fill in the gaps I’ve written this brief guide.
As most people that have traded forex already know, forex is not traded on an exchange but rather it’s traded on an over-the-counter (OTC) basis. Trading over-the-counter is a new concept if you have traded shares in the past as no two fx brokers will be exactly alike, this really is very different to share brokers who will always show you the same prices. Among the many other main differences is that because there isn’t a central exchange when trading forex over-the-counter there is no physical exchange of any currency but rather you’re trading directly with the broker, this means that when you open a position with your forex provider you can only close it with that forex provider nothing like trading equities where you are able to sell your shares through any stockbroker.
Now you understand the notion that forex trading is conducted on an over-the-counter basis I will start by explaining the fundamentals of price formation. As a result of the Over-the-counter nature of forex a good number of transactions arise between banks and forex brokers as such they are not reported on a central exchange, it is for this reason that price formation in the world of forex is more difficult, though like shares and all markets there are several key players in the forex trading world that make liquidity, these are the investment banks. Banks generate prices through their transactions with each other and in many cases they’ll quote prices through a system called EBS that enables one bank to see the prices shown by another bank. EBS however is not utilized by all investment banks, what this means is that there are other banks dealing on rates shown outside of EBS, essentially their own marketplace.
So what does this all mean to you? Well this means allot if you are dealing using a market maker or STP company who will basically offer you a price that they get from one investment bank or otherwise a price that they get themselves which is just based on the price they obtain from the bank that they deal with this means you may not always be getting a fair price. The excellent news is that there’s now an alternative, there are several fx brokers that can offer you an aggregated price feed from a variety of banks as well as allow you to participate in the pricing formation, which means that it is possible to place your own bids and offers amongst those offered by some of the world’s biggest investment banks. Brokers that offer this sort of facility are often known as ECN brokers.
ECN providers are hard to come by and function in a very dissimilar way to conventional forex brokers. Apart from the superior pricing obtainable by ECN brokers they’ll always charge commission, for most fx traders this is unheard of however to the astute trader this is actually the best way to trade. One of several major advantages to paying a commission over a spread is the fact that you actually know just how much you’re paying your forex provider, their fee is not hidden within the spread. Paying out a commission also means more opportunity, since you are paying the natural market price you’re able to get choice or even inverted spreads something you’ll never see using a conventional forex provider.
Before you all send me a million emails wanting to know which forex broker I deal with I might as well save some space in my gmail account and let you know right now. Before I let the cat out of the bag I do need to make it extremely obvious that if you look hard enough it is also possible to find a number of ECN brokers, just ensure you carry out your groundwork prior to opening a real trading account as there are many fx brokers out there that claim to be ECN fx brokers but are in reality market markers. I have trialled practically all the ECN brokers and so-called ECN brokers and found that there is just one true ECN forex provider and this is also the company that I personally trade with, it’s Australian based broker IC Markets. IC Markets have the very best execution by a long shot and their pricing is the most accurate that I have ever seen. As nearly all of you already know I don’t promote any particular broker, I just trade using the broker that I feel has the best product and most transparent pricing and that forex broker is IC Markets.
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