What exactly happens when i make a trade?

Beginner Questions
1

hey guys im still relatively new to fx.

Im just trying to get a few things straight in my head an the first is what exactly goes down when I make a trade…

Example.
if I am looking at the EUR:USD pair, and I believe it will rise for whatever reason, I would buy the pair, for example 1 lot (100000) and the price is 1.5000. My account is in Australian dollars.

A. would my Australian dollars convert to the equivalent $150000 USD to purchase the 100000 Euros? and then any profit or loss in those USD be then converted back to my AUD?

or B. because I am going long the euro and short the USD, would I in a sense receive $150000 for shorting the USD and use that $150000 to purchase the 100000 Euros, then after closing the trade any profit or loss would be in USD, would it then use the AUD:USD rate to convert back in my AUD?

or C. another answer?

Thanks

2

Hello, lenzinger, and welcome to this forum.

The answer to your question is:

C. another answer

In the retail spot forex market (our little corner of the foreign exchange market), there is no buying or selling of individual currencies, or of currency pairs. We all use the terms “buy” and “sell”, because it’s convenient to do so. However, it’s misleading for newbies, like yourself, who are trying to grasp the mechanics of this market.

When we use the term “buy”, we actually mean “go LONG” or “take a LONG position”. When we use the term “sell”, we actually mean “go SHORT” or “take a SHORT position”. You can see why it’s easier for lazy people, like us, to just say “buy” or “sell”.

The terms “buy” and “sell” are firmly imbedded in this business. Traders, brokers, analysts, and teachers all use those terms; and, except for newbies, they all know what those terms really mean when they use them.

Let’s talk about what a currency pair is, and what happens when you “buy” or “sell” one of them.

A currency pair is simply a price — it’s the price of one unit of the base currency, as quoted in the cross-currency. As such, you couldn’t “own” a currency pair, even you actually “bought” one — you can’t “own” a price.

The cross-currency is often called the quote currency, because the price of the base currency is quoted in terms of the cross-currency. When you see a price given for a currency pair, you are seeing the price (current exchange rate) for the base currency in terms of the cross-currency. If the price of the EUR/USD is quoted as 1.5000, this means that €1 = $1.50 at this moment.

When you buy (go LONG) the EUR/USD, you are speculating on a change in the price of the EUR/USD. Specifically, you are speculating that the price will rise — that is, that the value of the euro, as priced in U.S. dollars, will rise. This speculation is similar to a bet — which you place with your retail forex broker — in which the broker will credit a profit to your account if the EUR/USD price does, in fact, rise; and he will debit a loss to your account if the price falls. The amount of that profit, or that loss, depends (1) on the direction and extent of the EUR/USD price move, as measured in pips; (2) on the value of each pip in terms of your account currency, and (3) on the size of your position, in lots.

In your case, with a EUR/USD trade in an account denominated in AUD, the value of 1 pip would fluctuate throughout the duration of your trade. But, the value which matters to you is the value of 1 pip at the time your trade is closed.

Keep in mind that the price of the EUR/USD is a price in U.S. dollars ($1.50 in the example, above). And 1 pip, in this trade, is 1/10000 of one USD. So (assuming your trade was profitable), we want to know how many pips were earned, and how much each pip was worth in AUD at the time your trade was closed. Then, factoring in the size of your position (i.e., how many lots, or what fraction of a lot, you traded), we will have the amount of your profit in Australian dollars.

Notice that you didn’t buy any euro, or sell any U.S. dollars, in the course of this trade. So, when you hear someone say that “buying a currency pair means buying the base currency and selling the cross-currency”, just ignore that erroneous statement. What you actually did was speculate on an anticipated price move which unfolded as you expected, earning you a profit.

So, if you earned a profit, who took the loss? Your broker did, because he had the other side of your trade. That is, when you went LONG a certain number of lots of EUR/USD at a particular price with this particular broker, he automatically became SHORT the same number of lots of EUR/USD at the same price at the same time.

Your broker is your “counterparty” throughout the duration of your trade. He starts out on the other side of your trade, and he remains on the other side of your trade, until you close the trade. Your profit is his loss, and the money credited to your account, when the trade is closed, comes out of your broker’s pocket.

But, don’t cry over your broker’s loss. At the moment that you place your trade, your broker becomes exposed to the other side of your trade — that is, he becomes exposed to losses, if you start showing a profit. But, he has the option of hedging his position (thereby offsetting his exposure) by trading upstream with one of his liquidity providers (banks).

As an oversimplified example, if you are LONG one lot, and your broker doesn’t want to remain SHORT one lot, he simply BUYS one lot (of the same pair) from his liquidity provider. Now, he’s perfectly hedged; and changes in the price of that pair do not affect his P/L. He has given up the opportunity to profit from your loss, in order to avoid taking a loss due to your profit. He is no longer “trading against you”, and his profit on your trade will come from the spread only.

Earlier in this post, I mentioned that what we do in this market is similar to placing a bet on the direction of price. If you don’t like the close similarity between speculating and gambling, then you’ll have to work out those issues in your own mind, in accordance with your own values.

But, the fact remains that, in the retail forex market, we are all small speculators, with no commercial interest in the foreign currencies in which we speculate. We don’t buy currencies, we don’t sell currencies, and we don’t exhange currencies. Nor does our retail forex broker do any of those things.

Instead, we merely bet that the multi-national corporations, and the giant hedge funds, and the national governments, and the other entities which do have a commercial interest in these currencies will push prices one way, or the other — and we want a piece of their action.

So, we place bets on large, leveraged positions (which we probably couldn’t afford to acquire for cash), and we place these bets with a special sort of broker — a retail forex broker — who isn’t in the business of physical currency exchanges, but is in the specialized business of handling highly leveraged bets on currency price moves.

3

Hi Clint

With full respect to you, I will argue in one point:

When we sell someone buys and this is not the broker, other traders! broker matches the buy orders and sell orders, when this matching take place, the order will execute! Broker will get benefit from every buy and sell.

If I am wrong, let me know why…

4

Excellent description of the process…

You mention ‘broker’ in this answer, but I believe these days there are more than one time of ‘broker’? The traditional broker and then the NDD or STP type accounts? Is the above process the same with these?

Let me know if you need clarification, I may not be explaining myself correctly.

Thanks

5

If that were true, then “brokers” would truly be brokers — brokering a transaction between a buyer and a seller. But, that’s not the case. When you buy, someone else sells, but that someone is not another retail customer; that someone is the broker, as I stated in my previous post.

If two traders take equal but opposite positions with the same broker at the same time, those two traders are not trading with each other. The trader who buys is buying from the broker; and the trader who sells is selling to the broker. In each case, the broker is counterparty to the trader.

[B]When you transact a trade in the retail spot forex market, you enter into a contract with your broker — you have no dealings with any other trader.[/B] Your broker will buy from you or sell to you at any time of the day or night for about 120 hours each week, whether he has another customer wanting to take the opposite trade at that time, or not.

Furthermore, when you transact a trade, your contract with your broker remains in force for the duration of your trade, regardless of what your broker may do to offset his exposure to your trade. In other words, if your broker offsets his side of your trade, by trading upstream with one of his liquidity providers, he then has two separate transactions going — one with you, and a totally separate one with the liquidity provider. You have no dealings of any kind with the liquidity provider. Your trade has not been “passed up the line” to someone other than your broker, as some people would have you believe.

The U.S. CFTC has published some extensive rants on the distinction between a “dealer” and a “broker”, and they insist that [B]every retail forex broker is technically a dealer, not a broker.[/B] The CFTC will not use the word “broker” to describe these businesses. They insist on calling them Retail Foreign Exchange Dealers (RFED’S).

Here’s one way to think about the difference between a dealer and a broker:

A retailer who buys and sells gold and silver bars and coins is a [B]dealer.[/B] If you walk into his store, he will quote you one price (his BID price) if you want to sell, and a higher price (his ASK price) if you want to buy. If you sell to him, your bars or coins will go into his inventory. If you buy from him, you will buy out of his inventory.

You and I could be standing at the counter in the coin store at exactly the same time. You could be wanting to buy a one-ounce gold Canadian Maple Leaf coin, and I could be wanting to sell exactly the same thing. Your purchase would not involve me in any way, and my sale would not involve you in any way. We would each be dealing only with the coin dealer.

On the other hand, consider a real estate [B]broker.[/B] If you want to sell your house, and I want to buy your house, the real estate broker — who is a true broker — will put us together so that you are selling your house directly to me. The broker in this case facilitates the transaction — brokers the deal — and earns a commission for his/her effort. But, the broker does not buy your house from you, and then sell it to me.

The description I gave (in my previous post) of how a retail forex trade is carried out, illustrates the fact that our brokers are not “brokers”; they are “dealers”, just as the CFTC claims. Nevertheless, we all refer to our brokers as “brokers”. The word “broker” is imbedded in this business, in the same way that the words “buy” and “sell” are imbedded. We will never get rid of those words, and the way we misuse them, despite the CFTC’s rants.

6

Let’s define two types of brokers:

B[/B] Dealing-desk brokers. These are also known as market-maker brokers. In your question, you referred to these brokers as “traditional brokers”.

B[/B] Non-dealing-desk brokers. There are two kinds of non-dealing-desk brokers: STP brokers (straight-through-processing brokers), and ECN brokers (electronic-communications-network brokers).

The differences among these various types of brokers have to do with whether, and how, a particular broker hedges (or offsets) his exposure to customer positions in his upstream market. More on this in a moment.

[B]Regardless of whether, or how, a broker hedges his exposures, he remains the counterparty of each retail customer. Accordingly, each customer’s profit represents a loss to the broker; and each customer’s loss represents a profit for the broker. This seems to be the point which is most difficult for many newbies to grasp.[/B]

If the broker is fully hedged upstream, then the losses he takes, due to profits earned by his customers, are fully offset by profits flowing to him from his upstream positions. Likewise, the profits flowing to the broker, due to losses taken by his customers, are canceled out by losses taken in his upstream positions. In other words, a broker who is fully hedged upstream has no [U]net[/U] exposure to profits or losses resulting from his customers’ trades.

Nevertheless, the broker — regardless of what type of broker he is — cannot shed his contractual relationships to his retail customers, no matter what deals he makes with his upstream liquidity providers to hedge those relationships. Therefore, he remains exposed to both profits and losses from his downstream customer relationships, even if he cancels out all of those profits and losses through transactions made upstream with his banks.

Regarding whether, and how, different types of brokers hedge their exposure to their customers’ positions in the market, I hope that the following brief descriptions will be adequate.

A dealing-desk (market maker) broker will pick and choose the customer positions to hedge. If the trader manning the dealing-desk believes that a particular customer position will be profitable (for the customer), the dealing-desk trader will hedge that position upstream, so as to offset the loss (for the broker) which will result from the customer’s profit. On the other hand, if the dealing-desk trader believes that a particular customer position will be a loser (for the customer), then the dealing-desk trader will forgo the upstream hedge, in order to profit from the customer’s loss. In other words, the dealing-desk trader trades against the customer, seeking to profit from the customer’s losses.

A non-dealing-desk broker, on the other hand, will hedge all customer positions, maintaining (on average) a neutral exposure to the market. The dealing-desk trader described above is replaced by computer algorithms which continuously trade upstream (with the banks) in such a way that the broker cancels his exposure to both the profits and losses of his customers. A non-dealing-desk broker does not trade against his customers. His profit comes from a portion (the mark-up) of the spreads charged on each customer trade.

The difference between an STP broker and an ECN broker is basically where their upstream trades are handled. An STP broker trades directly with his affiliate banks — essentially top-tier banks in the interbank network (Deutsche Bank, CitiGroup, Barclays Capital, etc.) — through lines of credit negotiated with these banks.

An ECN broker, on the other hand, trades through an intermediary entity (the ECN), which functions to match equal and opposite retail customer orders, so as to cancel out (where possible) the need for upstream (bank) liquidity. Many people interpret this process as the retail broker passing his customers’ orders directly to an ECN, which then becomes the customers’ counterparty. This is not correct. Regardless of whether customer orders are offset directly through a bank, or through an ECN, the retail spot forex broker is the customer’s counterparty for as long as the customer’s trade remains open.

Being the customer’s counterparty in every instance means that the broker has the opposite side of every customer trade. And we have discussed over and over again that this means customer profits generate broker losses (whether offset, or not); and customer losses generate broker profits (whether offset, or not).

7

Clint, thank you very much. That explains it perfectly.

So in short, when a broker tells you they want you to succeed in traing, its actually better for them if you don’t?

8

Thanks Clint that was so helpful and explained in such a clear way for us newbies to understand. It’s much appreciated!

9

It’s a little more nuanced than that.

A broker who earns his money solely from the spreads which he charges his customers, wants as many customers as possible, and he wants them to trade as often as possible in the largest position sizes possible, for the longest period of time possible. That’s how the broker maximizes his spread income. Obviously, he wants you to stay with him forever, and place tons of trades. If every one of your trades is a winner, that’s even better — it probably means that you will remain a loyal customer, and keep trading big. Clearly, we’re describing a non-dealing-desk broker here.

A dealing-desk broker, on the other hand, tries to accomplish a balancing act: since someone is going to profit from your losses, he wants to be that someone; and, since someone will have to pay you your winnings, he wants that to be someone else. In other words, he tries to be clever enough to hedge your winning trades (the ones that would otherwise cost him money), but not hedge your losing trades (the ones that will pay him a profit). If the dealing-desk broker can do this successfully, then obviously he wants you to win often enough that you’ll stay in the game, and go on to trade even bigger; but, he also likes it when you lose, because your losers put a lot more money in his pocket than your winners do.

If this dealing-desk broker could write the script, he might arrange things so that you win 60% of the time, and each time you won, the broker’s hedge would protect him from taking the corresponding loss. But, you would lose the other 40% of the time — and all of your losses would go straight to the broker as profits. [B]The potential to capture those profits (from customer losses) is precisely why dealing-desk brokers are dealing-desk brokers.[/B] Is this corrupt? Not necessarily, although many retail traders are turned off by the apparent conflict-of-interest between dealing-desk brokers and their customers.

Nevertheless, dealing-desk brokers don’t want you to wipe out. On the contrary, they want you to stay with them forever, trade heavily, and let them harvest the profits from your losses.

If a dealing-desk broker [B]causes[/B] you to lose, so that he can profit, that’s a different matter, altogether. Now, we’re talking about a sort of fraud that’s very hard to prove. Because there’s the [B]possibility[/B] of this kind of fraud, many traders assume that it’s occurring. Some traders begin to blame their dealing-desk broker for every loss they take. Some go onto the internet, and call specific brokers crooks and scams. And some just avoid dealing-desk brokers altogether.

However, an example of a successful dealing-desk broker is Oanda. They call themselves a “market-maker”, rather than a dealing-desk broker (but, it’s the same thing, as we’ve discussed previously). I’ve seen claims that Oanda is the largest retail forex broker in the world. I can’t verify that, but I know that Oanda is big, and apparently customers are [B]not[/B] fleeing Oanda to escape from “the evil dealing-desk”.

10

Clint, you are a huge wealth of knowledge… really appreciate the quick replies and information.

Thanks

11

Hey Clint

I have another question in respect to your explanation that we (traders) are not trading with each other rather with our broker. Fine, understood.

Now my question is how we are seeing the same price from every broker’s platform? We are able to place our trades at those price (with some slippage in some cases)! I am placing my trade in an universal price with is not set by my broker, if it were , we could not see the same price on different platforms on different brokers! How you will explain it?

I agree that we are trading with our broker but how the same price is everywhere and we are able to place trades on those price! How all the brokers showing the same price!

12

Hello, dollareuro.

Sorry for the delay in replying to your question. I haven’t had much time for the forum over the past couple of days.

Regarding your question, retail brokers do not all quote [B]exactly[/B] the same BID and ASK prices to their customers, for the following reasons:

B[/B] they do not all apply the same mark-ups to the wholesale BID and ASK prices offered to them by their liquidity providers. If they did, there would be no difference in the spreads offered by various brokers, and there would be no discussions in forums about which broker has the best spreads.

B[/B] they do not all have business relationships with the same group of liquidity providers. So, the wholesale prices quoted to various retail brokers can vary from one broker to the next. Those wholesale prices are the basis for the retail prices which those brokers offer to the retail public. If two brokers are quoted slightly different wholesale prices, those slight differences will be passed through to their retail customers.

Nevertheless, the wholesale BID and ASK prices quoted by the big banks in the interbank network (the liquidity providers) to the brokers they are affiliated with, tend to be [B]very nearly[/B] the same. And the retail BID and ASK prices offered to us (retail forex customers) tend to be [B]very nearly[/B] the same. And it has to be this way, for the following reason.

There is a fundamental market reaction preventing any one bank or broker from straying far from the consensus prices in the market — and that’s called [B]arbitrage.[/B] Here’s a simple definition: Arbitrage is simultaneously buying and selling the same thing in different markets, in order to capitalize on pricing differences.

Let’s talk about banks first.

If one of the banks in the interbank network were to offer prices which differ by more than a certain amount from the consensus prices of the other banks, arbitrage between banks would immediately occur.

It would go something like this: Let’s say that Bank A quotes the EUR/USD at 1.2923/25 (that is, 1.2923 BID and 1.2925 ASK), while Bank B is quoting prices of 1.2897/99. In this scenario, astute players at the interbank level (possibly including some big retail forex brokers) would buy a ton of euro from Bank B at 1.2899 ASK and simultaneously sell the same number of euro to Bank A at 1.2923 BID, making a quick, risk-free profit of 24 pips. On a $10M purchase and sale, 24 pips is $24,000 profit.

In the scenario above, it doesn’t matter which bank’s pricing is out of line with the market — or, if both banks’ pricing is out of line. The arbitrage would be executed exactly the same way, regardless; euro would be bought from the bank asking the lower price, and sold to the bank bidding the higher price.

That was an extreme example. Such large discrepancies in prices between banks just don’t happen. But, smaller price discrepancies can be profitably exploited by arbitrageurs who have the necessary electronic connections to the banks in question. How small a price discrepancy can they profitably arbitrage? I can’t answer that. But, the fundamental market reaction which I referred to (4 paragraphs back) ensures that wherever the threshold is, if the threshold is crossed, arbitrage will occur.

And here’s the main point: Arbitrage drives price discrepancies back below their thresholds. In the example above, arbitrage would drive Bank A’s price for the EUR down, and/or drive Bank B’s price for the EUR up, depending on which of the two banks was out of line with the market.

In the interbank market, banks advertise their BID and ASK prices to each other through one of two electronic networks: Reuters or EBS. Any bank subscribing to either of those networks can instantly and contiuously see what all the other banks are bidding and asking for every currency pair out there. Each bank seeks to maintain a slight edge in pricing over their competitors. But, they don’t want to be arbitraged; so, they keep it close.

Now, let’s talk about retail brokers.

If a particular retail forex broker’s prices get out of line with the consensus of the market, arbitrage similar to what I described above will drive those prices back to the market. But, opportunities to do this sort of arbitrage at the retail level are few and far between, and doing it is very difficult for the average trader.

To give one real-life example, the only time I’ve personally seen a discretionary trader manually pull off a successful arbitrage, it was during the first few seconds immediately following an NFP release, several years ago. The NFP number, which was later revised, shocked the market, causing a huge plunge in the USD. Accordingly, the EUR/USD spiked upward somewhere between 80 and 100 pips, before collapsing to a more reasonable level. But, one broker’s EUR/USD prices (both BID and ASK) hung near the peak of the spike for several seconds [B]after[/B] the market seemed to be saying that the consensus price was substantially lower. That broker’s BID price was a sitting duck, and it was sold heavily for a very big, very quick profit.

That trade was possible only because the trader had access to price feeds from several sources (other than his own broker), and was able to determine (1) a market consensus, and (2) that his own broker was out of line with the consensus. Most traders would have to wait years for an opportunity like that one to come along.

A more common type of arbitrage at the retail level involves detecting and trading pricing discrepancies in currency crosses. Example: if EUR/USD is 1.2897, GBP/USD is 1.5026, then EUR/GBP [B]should be[/B] 0.8583 (because EUR/USD ÷ GBP/USD = EUR/GBP, so 1.2897 ÷ 1.5026 = 0.8583). If the quoted price for the EUR/GBP is substantially different from this calculated price, then arbitrage is possible [B]for algorithmic traders with fast connections to the market.[/B] Such price discrepancies in currency crosses are very fleeting, and manual traders are seldom fast enough to arbitrage them.

As in the bank example and the broker example given above, arbitrage always tends to drive prices back toward some equilibrium level, which I am calling the market consensus. Arbitrage occurs whenever the market contains price discrepancies. But, it’s not a game for the average retail trader to attempt to play.

13

In other words, a broker will lend you the money to match you buy order. You borrowing ability depends on the capital or account balance.

14

Retail forex brokers do not lend money.

Retail forex traders do not borrow money.

Retail forex traders do not buy or sell currencies.

15

I do appreciate these indepth answers Clint.
I just cant seem to put my finger on what im not 100% sure about, I just havent had that " ahh haaa" moment.

16

Waw Clint! Such a long reading by me and what a detail reply from you! I remember my course ‘International Financial Management’ while doing my MBA…

Thanks

17

What a thread!

Thanks sir Clint and to everyone who participated, I’ve learned so lot just by reading the thread.