Broker Compensation - Commission and Spread

This lesson is not too long but the concepts are very important so please read it carefully and make sure you understand it.

As was explained in the previous lesson, the Forex Broker provides you with many services without which you would not be able to trade. Naturally, you pay the broker for their services. There are two major mechanisms for the broker to be compensated - either through commission (you are charged a small percentage of your trade as commission) or through the so called "spread".

The NDD brokers usually charge commission (or a combination of commission and spread) whereas the MM or "Dealing Desk" brokers charge "spread".

When using the spread, the currency pair price is not displayed as a single quote but as Bid (or Sell) price and Ask (Buy) price, which differ by a few pips.

You buy at the Ask price (the asking price of the broker) and you sell at the Bid price.

Take a look at the picture which shows the Bid (white) and Ask (red) prices for EUR/CHF displayed in a chart. The pair Bid/Ask quote is:

EUR/USD = 1.5847 / 1.5851


The Spread is the difference between the Ask and the Bid:

SPREAD = ASK - BID

In this case it is 51 - 47 = 4 pips (see the green squares in the picture). Of course the proper way to calculate it would be to convert both price quotes to pips:

15851 - 15847 = 4, but we just used 51-47 for simplicity

In a quote the Bid always comes first (on the left) and is always lower than Ask (on a very rare occasion they may be equal).

The way the Bid, Ask and Spread work is that if you, say, buy some amount of the EUR/USD and then immediately sell it, the broker will have made money on this transaction, because you bought the currency at 1.5851 and you sold it back (at a loss!) at 1.5847. So your trades will always start in the negative (whatever the spread is) before they turn into winners.

However, with most pairs, and especially the EUR/USD, where some brokers offer 1-2 pip spreads or even 0.5 pip spread, the cost of the spread is negligible, especially compared to fees and expenses in other markets and instruments like stocks or options.

Signals, Alerts and Managed Accounts

Some brokers may also provide you with “signals” or “alerts”. The signal is a message sent to your telephone or computer notifying you of certain market action, e.g. whether it is time to buy or sell, essentially telling you exactly what to do - Buy, Sell or stay out! The signals are usually not free, except for very basic ones, like for example “Notify me when the price falls below 1.3424”, which you can setup yourself.

There is also software you can buy which can generate the signals for you! This way you won't have to pay monthly fees to companies for their signals. Whether you prefer to buy a software and install it on your computer and operate it yourself (like, for example, the Forex-Killer Signal Generator software) or you would rather rely on a company and its team of investment specialists to provide you with the signals is a matter of preference but in general, the signal company is considered more reliable as you pay them monthly subscription fees and you will simply cancel your subscription if unsatisfied with their services.

An example of a Forex signal provider company is Forex Automoney. Signal provider companies take complete care of the trading decisions, selecting profitable trades for their clients across multiple currency pairs and timeframes. Forex Automoney, for example, provides 3 types of signal time frames (weekly, daily and short-term) across 18 currency pairs. All you need to do is select your preferred trading style and follow the signals!

Handing your investments over to a signal management company is a more hands-off approach most suitable for those who want a piece of the Forex market profits without burdening themselves with the nitty-gritty of it and who are ready to take the small hit of paying the management company fees in return for quality professional services and more free time for themselves.

Third party companies may also offer “managed accounts”, in other words accounts where you deposit the amount you would like to invest and the management company trades it on your behalf, without any participation on your behalf, with a small part of the profit being paid to it as compensation. This is similar to Mutual Funds where you invest your money and the Fund Manager decides when to trade and what. These services are usually more expensive than Forex signals.