UNIT A| Absolute Essentials

3. Doing Brokers Due Diligence

Due to enormous competition between Forex broker-dealers, they offer different features and advantages. However, choosing a broker is not an easy task for any new or experienced trader.

There are some key aspects like regulation and capitalization which speak for the reliability and competence of the organization and which can be measured following certain objective criteria.

But the real challenge in choosing a broker comes when you have to determine what attributes you are looking for. Along with the outstanding features, you might find a potential weakness, depending on what you need for your trading style.

For example, if your trading performance depends on guaranteed liquidity but you can account for variable spreads, this may be what you should look for. On the other hand, you might prefer a fixed pip spread if you know you are getting instant executions despite of market conditions, if this is essential for your trading.

There are many Forex brokers to choose from, just as in any other market. Check our comparative table of brokers to see their main characteristics. It is a very comprehensive resource, allowing you to sort the brokers following your criteria.

 

With so many Forex broker-dealers out there, it may be a little confusing finding the one that fits your technical needs and financial capabilities. To that end, as part of the Learning Center, further below are the main criteria to look for when investigating a broker:

Screenshot of Broker Section

Support

One of the first thing you should check in a broker is the support service. Forex is a 24-hour market, so ideally, the broker you choose should offer support at anytime.

Which medium is used to contact the help desk: email, chat, or can you speak by phone to a live person? Do the representatives seem knowledgeable? How they respond to your questions can be key in gouging how they will respond to your needs in a real situation.

While trading you can run into technical problems. Therefore try to anticipate those critical situations and simulate those questions and requests to your broker. You can do this while experimenting on a demo account.

The website should already explain things clearly, but be sure to check the quality and efficiency of their support desk before opening an account.

Capitalization

As you already know, the better capitalized the market makers are, the more credit relationships they can establish with their liquidity providers and the more competitive pricing they can get for themselves as well as for their clients.

The OTC nature of the market makes extremely difficult for a broker to get competitive pricing without a margin deposited in a lending institution or bank. As a result, it is extremely important for individual investors to do extensive due diligence on the Forex broker with which they choose to trade.

If a broker-dealer states that they are safe to work with because they trade in the interbank market, you know what this means. To date, the interbank market is an unregulated and loose conglomerate usually traded by central banks, investment banks and extremely large corporations.

As a member of a regulatory authority, a broker must comply with a minimum capitalization level. This fact has a direct relationship with its ability to stay solvent and is also indicative of the size of the company.

The minimum capitalization required in the US is currently (Jun 2010) at $ 20,000,000. If the broker does not publish this information, it's a warning sign that could mean a lack of solvency.

As an auxiliary data you could try to find out if the broker has big clients such as hedge funds or corporations. Some of these data are public as regulated and audited hedge funds have to mention their access gates to the market. A broker chosen by a large hedge fund is normally indicative that the broker is reliable, complies with all regulations and has enough liquidity.

Regulation

Not all countries supervise the Forex brokers and dealers the same way, nor do they have the same regulatory environment and requirements when it comes to financial registration. Therefore, it is important for any trader to choose a broker that is based in a country where their activities are monitored by a regulatory agency. It is also important to know if the broker or dealer is regulated in an on- or offshore country, as the latter can be more liberal with registration requirements.

You want to be aware of the broker or dealer's regulatory status and have a clear understanding of the regulatory body that governs Forex activity where the selected broker or dealer does its business.

The authority of a regulated Forex broker is located in the country where the broker is registered in. For example, Forex brokers in the US should be registered as a futures commission merchant (FCM) with the Commodity Futures Trading Commission (CFTC). The CFTC ensures that the broker meets strict financial standards. The broker should also be a member of the National Futures Association (NFA).

US companies supervised by these three organizations are more likely to be legitimate than those that are not. In addition, there is a lot of information that can be found with these organizations that can help you further your broker research.

Dealing with a Forex broker-dealer that is registered with the CFTC and the NFA is one way to minimize your vulnerability, but this isn't to say that you should dismiss firms that are based outside the United States or subject to non-US regulators. The Financial Services Authority (FSA) in the United Kingdom, the Australian Securities and Investment Commission (ASIC) and the Investment Dealers Association of Canada (IDA) are also strident in their defense of the rights of retail Forex traders.
The point is to do your due diligence on a regular basis verifying that the firm is registered and in good standing with the regulator in place. Also, make certain that you understand your rights and the enforcement mechanisms available to you should you have difficulty with the broker-dealer.

How do these regulatory authorities keep Forex brokers straight? One of the measures which regulated Forex brokers need to take is to periodically submit financial reports to the authorities. Failure to provide the mandatory information can lead the authorities to remove the broker from their member list.

The regulatory authorities protect traders against fraud, scam and illegal trading practices. In case something goes wrong with your deposit, withdrawal or even with a market position, you can complain, sue or file an appeal regarding your Forex broker.

Do your due diligence before dispatching cash over the Internet. Make sure the entity you are sending money to has satisfied your background check and that they are registered in a country with strong legal laws.

There are some dramatic changes occurring in the financial markets that will affect currency trading. Don't proceed your reading before you listen to what Rob Booker explained in this webinar recorded in May 2008:

Explicit and Implicit Trading Costs

The Forex market, unlike other exchange driven markets, has a unique feature that many market makers use to entice traders to trade: they promise no exchange fees or regulatory fees, no data fees and, best of all, no commissions. In the previous chapter we have already mentioned that this advantage has to be well understood, because when it comes to evaluating costs, it much depends on your trading numbers such as frequency, ratios and other performance related statistics.

Basically, there are three commission structures used by Forex brokers: a fixed spread, a variable spread and/or a commission charge based on a percentage of the spread. Just a quick reminder: spread, usually calculated in pips, is the difference between buying and selling price.

So, which is the best choice?

On the one hand, you may think that the fixed spread is the right choice, because then you know exactly what to expect. On the other hand, you might think you are getting a good deal paying a variable but smaller spread.

First of all, consider that the best deal you can get is choosing a reputable broker who is well capitalized, has strong relationships with the large foreign exchange banks and can provide the liquidity you need to trade well. Second, you need to calculate the impact of all possible fee structures on your trading model to know which one is more favorable to you.

Some Forex brokers don't charge a commission, so the spread is how they make money. The lower the number of pips required per trade by the broker is, the greater the hypothetical profit that the trader makes is. Comparing pip spreads of half dozen brokers will reveal different transaction costs.
In the case of a broker who offers a variable spread, you can expect a spread that will, at times, be as low as 1 pip or as high as 7 pips on the most major pairs, depending on the level of market volatility.

While market makers provide two-way pricing to customers throughout the day, these prices can be quoted on a fixed basis, meaning that they do not move throughout the day. But they can also use a dynamic spread system, which means the prices change as the liquidity in certain pairs change.

A lack of liquidity in the markets or very volatile market conditions can force the broker to apply a slippage on the pricing. Slippage, also called "requote", occurs when your trade is executed away from the price you were offered, when you end up paying more pips than the average spread. This is perhaps a cost that you don't want to bear if you are trading very short term or if you trade based on economic data releases (news-trading).

Asking your broker how they handle news times and if they have any devise to protect you from experimenting slippage is probably a good idea. You can decide to trade with fixed spreads, even if they are a little higher in average but receive, in exchange, an instant fill of your trades at the desired prices.
Some brokers even offer you the choice of either a fixed spread or a variable one.

Other brokers, like ECN brokers, may also charge a small commission, usually in the order of two-tenths of one pip. Whether you should pay a small commission depends on what else the broker is offering. For example, the broker may pass your orders on to a large market makers conglomerate. You might choose a broker with such an arrangement, if you look for very tight spreads only larger investors can otherwise get.

Nevertheless, the spread with an ECN broker is not fixed, and it always depends on the current market depth. Besides, their platforms may not be so user friendly as retail platforms and they usually lack charting tools. In addition, payment and withdrawal options are less efficient when compared to retail brokers and accounts openings require higher minimum amounts.

But if a broker offers, in exchange of a commission, access to a superior proprietary software platform or some other benefit like a real time news feed, in this case, it may be worth paying the small commission for this additional service.

So what is the bottom line effect of each type of spread or commission on your trading? Given that it much depends on your trading profile, this is a difficult question to answer. There are some factors to take into account when weighing what is most advantageous for your trading and that depends on your trading capabilities and preferences.

An important and not very discussed aspect when considering trading costs are the rollover charges. These are determined by the difference between the interest rate of the country of the base currency and the interest rate of the other country. The greater the interest rate differential between the two currencies, the greater the rollover charge. We will cover these concepts in more detail in the next chapter, but as a matter of broker choice, take into account that not all brokers charge the same rollovers for the same pairs.

However, before you jump in and choose a broker based on the type of commission structure, consider the total broker's package, otherwise you may be sacrificing other benefits. For example, some brokers may offer excellent spreads but their platforms may not have that personal preference feature you need for your trading to work.

The information you gathered up to this point will make you enjoy the following webinar, in which John Jagerson teaches not only about the different spread typologies, but also shares a great amount of useful market knowledge for your broker-dealer research.

Platforms

The existing Forex brokers offer different trading platforms for their clients along with extensive tools and research. These trading platforms almost always feature real-time quotes for several currency pairs, integrated charting and news, technical analysis tools, a deal log and even integration for automated trading systems.

Real-time exchange rate quotes are not the only feature a retail platform should provide. Closely examine the screen layout in search for an account summary with your current account balance with realized and unrealized profit and loss; the margin available and locked in open positions; leverage; rollover charges in open positions; open position sizes, and performance reports.

One of the reasons why some of the trading software applications look similar is because some dealers, instead of creating their own software, prefer to offer other platforms for client use which were created by the same manufacturer and "white labeled". Regardless who is the creator, the important factors are always the same: intuitive design, ease of use, speed and reliability.

One of these white-label platforms is the popular Metatrader 4. MetaTrader 4 combines an accessible, user-friendly interface with a wide range of powerful of functions, making it a highly flexible platform. Visit our dedicated MT4 section to look for costum indicators, expert advisors, many of them reviwed and commented by our experts.

Screenshot of MetaTrader Section

Most trading platforms are either Web based (in Java), or download trading platforms you can install on your computer.

Which one is better? This is something you should decide by yourself. Web based software is hosted on your broker's server. You won't have to install any software on your own computer and you'll be able to log in from any computer that has an Internet connection.

It should be pointed out that, in most cases, you will only find trading platform applications to run on Microsoft Windows. Using another operating system, you won't be able to install the application and a web based or Java-based trading platform is the solution for those cases.

Java-based software tends to be less vulnerable to attacks from viruses and hackers during transmissions than client-based software. But on the other hand, the client-based programs run faster.

A client-based software will only allow you to trade on your own computer, unless you install the program on every computer you use.

Whether download or web-based, make sure that the trading set-up has every trading tool you need, including charts, news, available currencies etc., and that you have a high speed Internet connection. The Forex market is a fast moving market and you will need up-to-the second information to make informed trading decisions.

Speed is thus a little bit more subjective and can depend on the speed of your computer and Internet connection. But the actual technology is probably less important than knowing how fast someone will pick up the phone should you have a problem with the software and need to get out of a trade.

You are free to use a charting platform and an execution (trading) platform from two different providers, and even add a news feed from a third source.

Nearly all brokers align their hours of operation to coincide with the hours of operation of the global Forex market: 5:00 pm EST Sunday through 4:00 pm EST Friday.

Perhaps other valuable differentiators for you are trailing stops to lock in profits, real-time news, wireless trading, or pattern recognition charting.

One of the backbones of any trading platform is the ordering system, whether you can hedge positions, increment or reduce the size of a position, trail stop loss orders, close and invert a position, etc. Get a feel for the options that are available by trying out different demo accounts. Order types will be covered in next Chapter A03 in more detail, but for now remember that the decision about what order types are best depend on each trading style.

Brokers usually also provide technical and fundamental commentaries, economic calendars and other research as part of their service. Ask them if the information is freely available or only to costumers, and compare it with other sources.

Before committing to any broker and opening a real account, be sure to request free trial accounts, so-called "demo" accounts, to test the platforms and its many features. The demo account should be free at least for 30 days, so you can paper trade the platform and test if it fits your needs.

Account Types

Many brokers offer two or more types of accounts. These can be very small mini-accounts and even smaller micro-accounts, or standard accounts, depending on the lots traded. A lot consisting of 100,000 units is called a standard lot; a lot consisting of 10,000 units is called a mini lot; and a lot consisting of 1,000 units is called a micro lot. Some brokers even offer fractional unit sizes which allow you to establish your own position size.

The micro and mini-accounts allow you to trade with a very low minimum of capital, while the standard accounts often require a higher minimum initial capital, varying from broker to broker.

As you see, the account types differ from each other according to the minimum trading size requirements. Choosing a specific account type should be relative to your amount of capital. This concept may seem a bit nebulous if you are just starting out, but rest assured it will be made clear once you start learning about leverage and money management.

Margin Requirements and Leverage

Another thing that you should check in a Forex broker-dealer is leverage options and the margin call policy.

Foreign exchange traders, specially aspiring traders with limited capital, tend to like higher leverages and sometimes choose a broker based only on this feature. However, traders should remember that although higher leverage can lead to higher profits, it also increases the level of risk. Understand that leverage is like a loan. It might be just as beneficial as detrimental to your capital. Low margin requirements (meaning high leverage) are great when you make profits, but not so great when you loose.

Some brokers offer fixed leverage levels, while others adjust their leverage based on the currency that is being traded and may also have special policies for carrying a trade over the weekend. For example, less leverage (and therefore less risk) may be preferable if you trade highly volatile (exotic) currency pairs.

Traders should also take into account their broker's margin call policy. Some companies follow the FIFO (first in first out) method to close trades when margin requirements are not met by current equity, others follow the LIFO (last in first out) procedure, and some simply close all the trades. Depending on one's preferences, this is an issue that should be clearly identified before opening an account.

Maximum leverage levels are more of a concern for aggressive traders who like to use the highest possible leverage, whereas a moderate or conservative trader would be happy with the average leverage levels.

Most brokers pay interest on a trader's margin account. The interest rates normally fluctuate with the prevailing central bank's interest rates of the countries whose currencies you are trading. This is an interest which the margin capital in your account accrues. Ask your broker if there is a minimum margin requirement that allows you to accrue the interest.

Finding the right broker-dealers is a critical part of the process to become a trader and requires some real work on your part. Many of the mentioned criteria will be very relative until you define your trading profile and methodology. Therefore, don't forget to come back to this chapter as you progress in modeling your trader's profile.

Just to summarize: investigate, interrogate and cross-examine a series of Forex brokers before you jump in! Test broker's platform with demo accounts and make sure to scrutinize their terms and conditions to be fully aware of all the nuances that a specific broker may impose on your trading.

Here is a checklist you can use in your due diligence:

• How well capitalized is the broker/dealer?
• Is the company registered, and where? Get the firm's registration ID number and look it up at the above mentioned websites.
• How long has it been in business?
• Who manages the firm and how much experience does this person have?
• Does the firm have partner companies?
• Which and how many banks does the firm have relationships with?
• What is their capitalization level?
• What kind of platform does it offer- web based or client software?
• What is their margin policy?
• What rollover policy does the broker have?
• Does the firm guarantee stop loss execution?
• Does it have the order types that you need for your trading?
• Can you speak to the dealing desk if they have one?
• Do they guarantee liquidity also for big order sizes?