Forex broker evaluation criteria - what distinguishes the best online brokers
We use the following criteria for evaluating the forex brokers (or dealers):
We consider whether the forex broker has had regulatory action taken against it by the forex regulators. If a forex broker has a history of violating forex regulations, it may be that the broker has poor control over its business, or that it is trying to treat its clients unfairly. A forex trader should be aware of the regulatory violations of his forex broker. Do you want to trade your hard-earned money with a broker who breaks the law? It is unnecessary to deal with such brokers since there are brokers with good offerings who have a clean regulatory record.
We also consider which organization is regulating the broker, or whether any organization is regulating the broker at all. We prefer brokers who are regulated by the following:
- CFTC / NFA in the United States
- FCA in the United Kingdom
- ASIC in Australia
- CySEC in Europe (Cyprus)
These are the best regulators for trader protection. They have the strongest forex regulations and are most likely to identify and take action against violators. With the advent of the internet and all brokers being online, it can be difficult to know where your broker is located and who is regulating them. You may be surprised to know that many brokers are located in remote island countries with regulators that are very business friendly. These business arrangements may come at the expense of trader protection.
Counterparty risk refers to the risk that the entity you are dealing with cannot fulfill their contractual obligations. In practical terms, this will usually refer to the risk that your forex broker will go bankrupt, and you will lose your account balance. In most, but not all cases, you do not hold title to the funds in your account balance. You are essentially loaning the funds to the broker, and the broker is obligated to pay you back your account balance when you instruct them to. However, if the broker goes bankrupt, in most jurisdictions, forex traders are considered unsecured creditors. This puts you close to the last in line to get your money back, and it may be that you only get a portion of your account balance back, or not at all. Further, it can take years to get any money back at all. Forex broker bankruptcy happens more often than you think. MF Global, Crown Forex, Alpari UK, SkyFX, and others have all gone bankrupt.
There are several possibilities for managing this risk:
- Regulatory protection of account balances
- Segregation of funds
- Large capital reserves
- Using high leverage to keep margin deposits small
Regulatory protection of account balances. In various jurisdictions, regulation protects your account balance in case your broker goes bankrupt, up to certain limits. This is the strongest form of protection against counterparty risk, so it should be a consideration when selecting a forex broker. We assign green scores to brokers if applicable regulations will protect client deposits if their broker declares bankruptcy. Jurisdictions where account balances are protected include:
- IIROC, the Canadian forex regulator, provides protection of account balances up to $100,000, via the Canadian Investor Protection Fund. Protection extends to clients of Canadian forex brokers regardless of their residency or citizenship.
- FINMA, the Swiss regulator, provides protection of client account balances, up to CHF 100,000, via esisuisse. This protection extends to clients of all Swiss forex brokers, anywhere in the world.
- CySEC, the Cyprus regulator, requires Cypriot forex brokers to be members of the Investment Compensation Fund, which provides protection up to EUR 20,000.
- FCMC, who regulates forex in Latvia, provides protection of 90% of your account balance, up to EUR 20,000.
Segregation of funds. In some cases, clients account balances may be kept separate from broker operating funds in such a way that those account balances are protected in the event of broker bankruptcy. This was the case when Excel Markets went bankrupt in January 2015. However, great care must be taken when evaluating this mechanism. A forex broker may advertise that client funds are segregated, but their client contract or disclose statements advise that funds are not protected in case of bankruptcy. In these cases, the client agreement or disclosure statement always take precedence.
Large capital reserves. Capital reserves help to lower the risk of bankruptcy for the forex broker. The large reserves act as a buffer against wild market movements or "black swan" events that may force other brokers into bankruptcy. The Swiss Franc shock on January 15, 2015 showed that the regulatory net capital requirements were not adequate to protect all forex brokers from big losses and bankruptcy. As such, the best forex brokers protect their clients and themselves by maintaining a large net capital reserve. Most forex brokers must keep minimum levels of net capital reserves to meet the regulatory requirements. The best forex brokers usually keep much more than the minimum required by the regulation. We assign green scores if we are able to verify that a broker has large excess net capital reserve well above the regulatory minimum. We assign yellow scores to brokers who are subject to regulatory requirements to maintain capital reserves, but may or may not have significant excess reserves. We assign red scores to brokers who are not regulated to keep a capital reserve.
High leverage to keep margin deposits small. Great care must be taken when using leverage. Before following this advice, make sure you fully understand leverage and how it works. Babypips provides education material on this subject. The strategy outlined here describes how to use forex broker leverage limits to provide partial protection against the risk of forex broker bankruptcy. The following example illustrates this strategy:
- Peter has a $20,000 account balance with your forex broker. Peter is prudent with his money such that he leverages 5:1 and so his trades are usually around $100,000. Peter's broker goes bankrupt. As an unsecured creditor, Peter may lose most or all of his $20,000 account balance, and have to wait years to get any of it back.
- Henry has $20,000 that he wants to use to trade forex. He also wants to make $100,000 trades. However, he only deposits $500 in his forex broker account. This means that his trades are leveraged 200:1, but Henry's broker allows up to 500:1 leverage, so Henry has no problem making these trades. Now Henry's broker goes bankrupt. As an unsecured creditor, Henry may lose most or all of his account balance, but this is only $500 of the $20,000 that Henry has allocated for forex trading. The other $19,500 is kept safely in his own bank account with a tier 1 national bank.
If a forex broker goes bankrupt, it is obviously better to be Henry than it is to be Paul. However, Henry is at a much higher risk of a margin call if there is a significant market fluctuation, which may result in the forex broker closing his trade automatically. This may not be what Henry wants, so he needs to employ his leverage carefully. As a last point, do not leverage up to such high levels if $500 is all that you have available for forex trading. One or two significant market fluctuations can wipe you out. Henry has another $19,500 to draw on to top up his account, you don't.
This classifies the broker by whether it uses the market maker model, the straight through processing model, or is an introducing broker. We think that the straight through processing model is the best model. We do not like the market maker model because there is a stronger conflict of interest, though there are exceptions.
Forex traders should be aware that market makers choose the prices that they offer to their clients. They can choose to offer any price they want or not offer any prices at all. They have an incentive to see you lose money, since that means they are winning money. It is usually better to do business with a broker who does not profit so directly from your losses. Brokers who offer the straight through processing find an offsetting transaction to your trade before executing your trade. There is no incentive to them if you lose money on your transaction.
However, there are advantages to the market maker model. One of them is speed of execution. When you deal with a market maker, they execute your order immediately. They offset their risk in the market after the fact. Contrast this with the straight through processing model: In the USA, your broker first offsets your order with another counterparty, and fills your order afterward with the price that the broker receives from the other counterparty. These extra steps cause delays. Further, the USA rules allow a straight through processing broker to change the price of your executed trade up to 15 minutes after the trade is executed if the other counterparty changes their price. Market makers are prohibited from changing the price after the order is executed. Once the trade is completed, you know it will not change. Traders who scalp the market and require the fastest order execution should consider a market maker, because they typically have the best execution time, execution reliability, and execution certainty.
The Forex Trading Channel has a useful article about the different types of forex brokers, for more information.
The best forex brokers will offer low spreads and overall transaction costs compared to other brokers.
The transaction costs, which may include a spread and a commission, may have a significant impact on forex trading profitability. These transaction costs may seem small, but because forex trading usually uses high leverage, this multiplies the impact of the spread. The result is that a significant proportion of potential profits are lost to these transaction costs. This is especially so for traders who trade on the short timeframe charts like 15 minute charts or lower. For traders who trade infrequently using the daily charts, the spreads have much less of an impact.
The following examples illustrate the impact:
Example 1: frequent trader trading the 15 minute charts:
- average take profit and stop loss levels are 30 pips (reward:risk ratio = 1:1)
- win % is 55% excluding transaction costs
- broker A offers spread + commissions of 2.5 pips
- broker B offers spread + commissions of 0.7 pips
- Trades are leveraged 10:1, there are 450 trades per year, and the starting account balance is $30,000
The above assumptions mean that average profit per trade before applying transaction costs will be (30 pips x 0.55) - (30 pips x 0.45) = 3 pips
Using broker A:
- 83% of the gross profits will be lost to transactions costs
- 112% of the starting account balance will be lost to transaction costs per year
Using broker B:
- 23% of the gross profits will be lost to transaction costs
- 32% of the starting account balance will be lost to transaction costs per year
A frequent trader is much more likely to succeed with broker B instead of broker A.
Example 2: infrequent trader trading the 4 hour charts:
- average take profit and stop loss levels are 150 pips
- win % is 60%
- brokers A and B offer the same spreads as above (2.5 pips and 0.7 pips respectively)
- trades are leveraged 10:1, there are only 30 trades per year, and the starting account balance is $30,000
The average profit per trade before applying transaction costs will be (150 pips x 0.60) - (150 pips x 0.40) = 30 pips
Using broker A:
- 8% of the gross profits will be lost to transactions costs, and 7% of the starting account balance will be lost to transaction costs per year
Using broker B:
- 2% of the gross profits will be lost to transaction costs, and 2% of the starting account balance will be lost to transaction costs per year
For infrequent traders, the spreads and commissions have a much lower impact on profitability, so other factors may become more important when choosing a forex broker.
Accounts and Funding:
We consider whether a broker provides sufficient options for withdrawing money. We also consider whether those options are free of unreasonable fees. Forex brokers have an incentive to see you continue to trade so they can continue to make money. This creates an incentive for them to make it difficult to withdraw your money. Some brokers will charge a 3% fee on any money you withdraw, which is unacceptable for traders with large accounts. Other brokers charge high fixed withdrawal fees, which represent a significant percentage for a small trader. Yet others limit your withdrawal options to inconvenient methods. The best forex brokers don't force you to put up with poor withdrawal options, and so this should be a consideration in choosing a broker.
We also give more favorable scores to forex brokers if they offer permanent demo accounts. We believe permanent demo accounts are very important to beginning traders and experienced traders alike. It can take months or even years of practice to learn to trade profitably. As we discuss in our How To Start Trading Forex Safely article, you do not want to lose money during this practice period.
Whether there are sufficient options and flexibility for charting and placing orders, as well as profitability reporting functionality.
The user interface encompasses trading platform options, analysis tools like advanced charting, and performance reporting. The more options there are for trading platforms, the more likely you will find functionality that can lead you to profitability.
Most manual traders use various kinds of indicators in their charts to determine entry and exit points for their trades. It is therefore important for the forex broker to offer sufficient built-in charting indicators that traders use. Some of the most common indicators include:
- various moving averages (SMA, EMA, WEMA, TEMA, TRIX)
- various oscillators (RSI, stochastic, CCI, MACD)
- fibonacci indicators
- pivot point indicators
- Ichimoku indicators
- bollinger bands
- parabolic SAR
In the event that your trading system uses indicators that are not built-in, ideally the charting interface allows you to easily build your own custom indicators.
The best forex brokers will also allow for use of automated trading systems. Automated trading systems are programs that analyze the price action and give automated trading signals to the broker to execute. It is usually a hands off approach to trading where the program has full control over the currency pairs to trade, entries and exits, and position position size. Trading using automated trading programs has many advantages:
- They take the emotion out of trading. When you have real money on the line, it can be difficult to control your emotions. You tend to be governed by either fear or greed. You end up making decisions to satisfy your short term emotional urges, instead of your long term financial goals. Trading on emotion is one of the fastest ways to lose money over time. By giving trading decisions to the automated program, you take emotions out of the equation, because the program has no emotions. It just follows the rules you have put in place, and it follows those rules consistently.
- They allow you to trade 24 hours per day. If you trade manually, you can only trade for part of the day. THe rest of the time you have to eat, sleep and manage your personal affairs. Many traders also have a separate full time job, so they can only be in front of the charts of a small portion of the day. Automated trading programs allow you to participate in the market at all times that the market is open. IT frees up your time to do other things, and ensures you don't miss any opportunities.
- They can be backtested. Automated programs follow a consistent set of rules that can be tested against historical market data to see if they would have been profitable in the past. The best forex brokers have an interface that makes this fast and easy, allowing you to test years worth of trading in minutes or seconds. If they have not been profitable in the past, they are unlikely to be profitable in the future. Note that even if they were profitable in the past, it is no guarantee that they will be profitable in the future, but it increases your chances of success.
- Automated trading strategies react faster. This is particularly important for scalpers, who trade for very short periods of time. If the market moves against your trade, automated programs will get you out of the trade faster. If there is an opportunity, they will see it and enter the trade faster. No time is wasted thinking about the trade, or manually entering the order instructions.
Automated trading programs have some disadvantages you should be aware of:
- It is hard to get a good one. Regardless of what is advertised, the vast majority of automated trading programs that you can buy will not work in the long run, or even in the short run. Our article on forex scams goes into more detail on this. So your best bet is to create one your self. This can be difficult. It requires that you learn a programming language. You must expend a lot of time troubleshooting the program you create, and testing it for robustness. When you program a system you are happy with, it will not last forever. It's performance will degrade and you will have to start all over again. This takes more skill and patience than most retail traders have.
- It is easy to fool yourself. Whether you purchase an automated trading program, or create one yourself, it is easy to be fooled into thinking it will make you money, when in fact it will lose you money. When developing and testing a trading program, it is almost impossible to avoid what is alternately called over-optimization, data snooping bias, or curve fitting. This is a phenomena whereby the parameters of the trading program are selected to generate the maximum profit for the historical data. The problem is that history does not repeat itself. The parameters that were perfectly fit for the past will never fit as well in the future, and may in fact fail miserably. The more parameters used and optimized in the trading program, the better the chances of showing a profit in the backtest, but the greater will be the over-optimization effect. What this means is the best performing trading programs in testing are actually the worst trading programs in reality.
The MetaTrader platform is one of the most popular platforms for developing trading programs, or what they call Expert Advisors (EA's). MetaTrader 4 is currently the most popular platform, though MetaTrader 5 has more features, even though it is less well adopted. Note that MetaTrader 4 EAs are not immediately compatible with MetaTrader 5. Other trading program development options are available through cTrader, NinjaTrader, TradeStation, MultiCharts and others. Most of these development platforms support more than one broker, so if you are dissatisfied with one broker, you may be able to find another without starting over with a new programming language. Some platforms like MetaTrader are free for the trader, while others like NinjaTrader and MultiCharts charge a fee to use them for trading.
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Last updated 2016-09-03