One of the most common misconceptions about online forex trading is that, when you place a trade with a broker, you are actually buying or selling currencies. While this can be the case with some trading models, this is not the norm, and is in fact very rarely the case when trading on retail platforms.
In fact, most retail forex brokers, and many institutional-grade brokers, operate a system known as “market making”, in which the trader is merely making a bet with the broker that the price will move in the direction they anticipate. With this model, no actual currency transactions take place. Instead, the trade is simulated, based on a close approximation of the actual currency value fluctuations.
In simplified terms, this means that if the trader gets it right, the broker will lose out, but if they get it wrong, the trader will lose out, so in order to make money, the broker has to work on the assumption that there will be more traders that make a loss than make a profit, and in practice, this is usually the case.
This model is complicated, however, by the “spread” – the difference between the buying price (“bid”) of a currency pair and the selling price (“offer”). This difference means that, if the price remains roughly the same, the broker will still win out when the trade is closed. In order for the trader to win, they have to “beat the spread” and see the currency make a move in their predicted direction that outweighs this spread.
From a market maker’s perspective, the best outcome is often that the price does not move at all, and they can simply profit from the spread on the trades placed during that time. If there is a strong trend, there is the increased likelihood that their clients will make money from it, potentially leaving them out of pocket.
From the point of view of a trader, this needn’t be as bad as it sounds, and in fact there are many benefits to this trading model. For starters, the trades can be executed instantly, because you don’t need to wait for another trader to take the other side of your trade. In theory, this should take the issue of liquidity out of the equation, but in practice, spreads for illiquid pairings are considerably higher than those of liquid ones.
Also, it provides the flexibility to deal in smaller lot sizes, which can be very useful for retail traders who do not have millions of dollars in capital to trade with. To put this in context, the minimum trade size for a forex trade is 100,000 units – one standard lot – for example $100,000. Even with exceptionally high leverage such as 100:1, which would magnify tiny movements in price to an almost unacceptable degree from a risk management point of view, this would still make the minimum stake size $1,000 – again, an unacceptable risk for most retail traders.
With market making, traders can use smaller lot sizes such as mini lots (10,000 units) or micro lots (1,000 units), which in combination with reasonable leverage, makes the risk level much more manageable for the average retail trader, whose account might typically consist of hundreds or thousands of dollars rather than hundreds of thousands or even millions.
So while the market maker model might seem to place retail traders at a distinct disadvantage to institutional traders who are trading in real currencies via broker models such as Direct Market Access (DMA), in practice it actually levels the playing field to a certain degree. Of course, institutional traders still enjoy many advantages over the retail trader – greater resources, expertise etc – but the choice of broker model is rarely the most telling of these.