Here is a very good article written by Felix Homogratus about how to evaluate forex brokers before you open up an account with them.
Step #1: Does forex broker provide natural trading environment?
First step is to determine whether the forex broker provides natural trading environment or artificial trading environment.
Let me explain…
Bids & Offers Example. Let’s say you are trading the GBP/USD pair. Let’s say you want to buy GBP/USD. Let’s say you login to your forex broker account, and you see that the price is 1.9950/1.9953.
That means that somebody out there is willing to buy GBP/USD for 1.9950, and somebody else out there is willing to sell GBP/USD for 1.9953. So if you wanted to buy GBP/USD, you would have to pay 1.9953 for it. If you wanted to sell it, you would have to pay 1.9950.
Let’s say you want to buy GBP/USD, and you do not want to pay 1.9953 for it, but you would be willing to pay 1.9952 for it. So you go ahead and you submit a limit order to your broker to buy GBP/USD at 1.9952.
If that forex broker has natural trading environment, you should immediately see the price on GBP/USD change from 1.9950/1.9953 to 1.9952/1.9953. Why? Because someone else was bidding 1.9950 for GBP/USD and now you are bidding 1.9952.
Your bid of 1.9952 is higher than 1.9950, so in natural trading environment, that should immediately be reflected in the price, and the spread must shrink.
Please watch the following video to see example of this:
There are two major benefits that come from natural trading environment. First is that you get to benefit from true spread which can often be as low as ZERO. And second is that your stop/losses will get hit less often. Let’s look at each benefit in greater detail.
ZERO Spread Phenomenon. The ZERO spread phenomenon is a very interesting one and is only possible in non-centralized markets such as forex. Let’s discover how ZERO spread is possible in forex market.
In my opinion the goal of every honest forex broker should be to provide traders the best possible price available. The way they can do that is by choosing the best possible price from several different banks and from every trader on their platform.
So let’s say Bank A has price of GBP/USD as 1.9950/1.9952, and Bank B has price of GBP/USD as 1.9948/1.9950.
So what your broker does is it takes the lowest bid price from Bank A, which is 1.9950, and it takes the lowest offer price from Bank B, which is also 1.9950. Because bid is from one bank, and offer is from another bank, they can stay on your broker with ZERO spread without executing against one another.
Getting screwed on Stop/Losses. Let’s now discover why the stop/losses will get hit less often if you use a broker with natural trading environment.
Well…first of all, if the environment of the broker is not natural, it means that they constantly need to worry about the accuracy of their price.
Many forex traders trade during news, and when price gets very volatile during news, the forex broker with not-natural environment becomes afraid that the traders will take advantage of their price feed and will get filled on much better price than the real market price.
Because of that, the broker is forced to artificially raise their spread during news. It happens quite often that the spread is raised from 2 pips to 30 pips and sometimes more.
So if your stop/loss is 20 pips away, and the spread just got raised, even for 1 second, you will get stopped out on a price that you would never be stopped out on if you traded with broker that provides natural trading environment.
Every day is filled with many different news announcements, so if you do not have a broker with natural trading environment, you can get screwed on spread and stops very often.
Step #2 Does forex broker charge commission?
At first you may think that I am crazy. Why would I want to pick a broker that charges commissions over a broker that has only spread with no commissions? Let’s discover the answer to this question together.
Forex brokers are not charities. Their purpose is to make money. There are two ways brokers can make money. First is to charge commission. Second is to collect spread.
Charging commission is the only honest way a broker can make money. If the broker does not charge commission, that means they are making money from spread.
It should be impossible for forex broker to make money from spread in natural and honest forex trading environment.
The purpose of a forex broker should be to connect traders and banks. The purpose of the traders and banks is to compete with one another for best possible price. That competition is what determines spread in real trading environment.
The only way forex brokers can make money on spread is if they set their own “fixed” spread or add “extra” spread to natural spread. In either case it means manipulation of price.
There is only one party that can have control over prices. It’s either the traders or it’s the broker.
When traders control the prices, there is honest environment of supply and demand. When broker controls the prices, there is dishonest and artificial manipulation that is the root of many problems.
Manipulation of spread and prices is how most forex brokers screw their traders every day, and most traders don’t even know it. Most common way is to take out their stop/losses a lot more often than they should be taken out in normal trading environment.
But remember, many brokers that charge commissions also manipulate their spread, so they make money both ways.
The only way to know if the spread is real is to see if you can change prices with your orders as shown in video above.
Step #3 Is forex broker regulated?
What good is forex broker that you can trade and make money with, but when it comes time to take your money, they don’t give it to you, because they don’t have it?
Forex Broker Bust Story. Refco was the biggest forex broker that was worth around $4 billion dollars. In October of 2005, Refco shut down its operations and every trader who had money with them got screwed big time.
Refco was not regulated and for some time they were spending not only their profits but also deposits of their clients. The amounts of money that traders saw on their trading platforms and the amounts of money Refco had in their bank accounts were different by $400 million.
So when the news hit the wire that Refco is running at such deficit, traders panicked and started asking for withdrawals. The only problem was that Refco was $400 million short of what it owed to traders.
There was a trial of course, and whatever assets the company had the court ordered to distribute among traders. I knew some people that had money with Refco. As far as I remember, after all assets were sold they got around 10% of what was owed to them. That means if person had $10,000 in his trading account, he got only $1,000 of it.
Moral of Forex Broker Bust Story. What is the moral of this true incident? The moral is that we have to remember that every time we deposit money to any forex broker, the money goes into their bank account. Whatever balance we see on our platforms is not real.
The broker can spend all of our money, without us knowing it, and they can still run their operation for a long time by robbing Peter to pay Paul. But when there are no more Pauls to rob, Peters get screwed.
The purpose of regulatory agencies is to constantly audit forex brokers and make sure that they are running their business properly and that the funds that belong to their clients are in place.
There are private regulatory agencies and there are government regulatory agencies. Private agencies are usually less strict and not as serious as government regulatory agencies.
I suggest doing business only with those forex brokers whose parent company is regulated by at least one regulatory agency, preferably government one.
List of 5 Regulatory Agencies. Here is the list of some popular financial regulatory agencies in the US:
Name: US Securities and Exchange Commission
Status: US Government
Website: You can find out whether a forex broker’s parent company has a filing with SEC by going to: http://www.edgar-online.com/. There is also a search function on SEC website, but it does not go beyond 1994. Here is the link: http://www.sec.gov/edgar/searchedgar/companysearch.html.
Name: Commodity Futures Trading Commission
Status: US Government
Website: You can find out whether a forex broker’s parent company is a member of CFTC by going to this link, opening most recent PDF file and searching by broker’s company name: http://www.cftc.gov/marketreports/financialdataforfcms/index.htm.
Name: National Futures Association
Website: You can find out whether a forex broker’s parent company is a member of NFA by going to this link and searching by broker’s company name: http://www.nfa.futures.org/basicnet/.
Name: Financial Industry Regulatory Authority
Website: You can find out whether a forex broker’s parent company is a member of FINRA by going to this link and searching by broker’s company name: http://brokercheck.finra.org/Search/Search.aspx?PageID=1.
Name: Securities Investor Protection Corporation
Website: You can find out whether a forex broker’s parent company is a member of SIPC by going to this link and searching by broker’s company name: http://www.sipc.org/who/database.cfm.
Step #4 Does forex broker have good reputation?
Before doing business with any forex broker, it is very important to check on their reputation. When checking on reputation of a forex broker, you should ask three questions.
How long has forex broker been in business? First Question is how long the forex broker has been in business. First you should search their company name on their local government website, and see date of their incorporation.
Second you should check and see when their domain name was registered. You can check on the domain by going to this link: http://www.networksolutions.com/whois/index.jsp.
If either their company name or their domain name has been around for less than 3 years, I think it’s very risky to be doing business with that forex broker.
Media Coverage. Second Question is whether the forex broker had any articles in any major financial newspapers. The easiest way to check that is to ask them. Most companies that had positive media coverage will save that information and post it on their website.
I think that doing business with forex brokers that did not have any articles in major financial newspapers is risky, because that usually means that they are either too small or haven’t been around long enough.
Reviews of Clients. Third Question is what do former and current clients say about the forex broker. Best thing you can do is go to http://www.forexpeacearmy.com/public/forex_broker_reviews, find your forex broker in the list and read reviews about them.
I would avoid forex brokers that have less than 20 reviews, because it means that they are very small. I would also avoid forex brokers with a rating of 2 stars or less.
I suggest reading through the reviews with great discretion, and look for reviews with specific details about certain issues and problems
Step #5 How much does it cost to withdraw money?
In my practical experience as a forex trader for quite a few years, I think it is very important to find a forex broker that allows you to withdraw money as often as you like at no cost or very little cost.
Perhaps you are different, but for me one of the keys for keeping my profits was to constantly withdraw them. If I left profits in my trading account, I had a tendency to take more reckless trades and lose them much quicker than normal.
But when I was back to core balance or below, somehow I would get more conservative and more careful and bring the balance to positive again. Even if you want to grow your account by keeping the profits there, I suggest withdrawing them first, and then re-depositing them. This way, mentally your profits become as core balance.
I have dealt with some brokers that charged a lot for withdrawals and even penalized for frequent withdrawals. Even if I had thousands of dollars in profit, and it cost $30 for a withdrawal, psychologically I was not inspired to withdraw profits. I would wait, and try to consolidate my withdrawals, and every time I did that, I usually regretted it.
So to make the long story short, before opening an account with a forex broker, call them and tell them that you are planning to withdraw money 10 to 15 times per month, and ask them how much it would cost.
You may be surprised to find out that with such withdrawal activity, you may be losing extra $500 to $1,000 per month just in withdrawal fees.
I believe that we as human beings are conditioned to efficiency, so if we have to pay money to withdraw profit, we won’t do it as often as we should, and it can end up costing us thousands and tens of thousands of dollars in lost profits due to psychological effect this will have on us as forex traders.
So I think it’s best to find a forex broker that will allow you to withdraw money as often as you wish. In addition to that, they must have at least one withdrawal option that costs under $10 per withdrawal, and takes 1 week or less to receive.