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Disclaimer

The contents of this blog do not constitute investment advice. Trading CFDs and Forex can be very risky and you can lose much more than your initial deposit. Seek professional advice before making any trades.

Why your broker always wins

No matter whether you win or lose your broker or spread betting company should always be making money. Just look at IG Group’s financial reports for instance. They are making a huge amount of money every day – their latest trading update for their financial year predicts a profit before tax of £125 million. Clearly allowing people to trade with spread bets, CFDs and Forex is good money.

These companies make money from you in a variety of ways.

Spread and commission

There will be a direct charge for each bet or trade you place. This will be in the form of the spread or commission, and could even be both.

It is quite obvious that commission will generate money for your trading account provider. You place a trade and a certain percentage of the value of that trade is taken in payment for making the trade. When you close the trade it is likely that you will be charged commission again.

The way they make money out of the spread is a little more complex. It depends on whether you are a winner or loser, and also on how your broker hedges your bet.

Most people are making fairly small trades and most of the time they lose. If your broker can count on you losing more than you win then they can simply pocket your losses as profit. The spread helps to amplify your loss as you need to be ‘right’ by the amount of the spread just to break even on the trade. Remember the moment you enter a trade you have made a loss. You have to make up your loss before you can begin to make a profit.

Even if 50% of trades were winners and 50% were losers your broker would still make a profit because of the spread. There would probably be minimal need to hedge your trades in the real market as there are so many trades in different directions that they will tend to cancel each other out.

If your broker is forced to hedge the trade – either because you are 1) betting very large, 2) because the cumulative positions of thousands of people’s trades is skewed in one direction, or 3) because some kind of risk level is hit, they can still make money very consistently. This is because they will be hedging against the values of the trades in bulk, and because when they do this they will be paying a much lower spread than is available to you.

If you win then they pass the winnings to you – of course pocketing the difference between the spread they pay and the spread you pay. If you lose then a similar thing happens. You (and your broker) have lost the trade but of course it was your money and not your brokers. This leaves them to pocket the difference between the spreads. Again they win!

The fastest way for them to make money is to directly bank your cash rather than hedging in the real market so in general they won’t hedge trades unless their risk models tell them to. These risk models could either be based on the net positions of all the trades on their system, or could be based on how individual traders perform. Successful big money traders require hedging against whilst unsuccessful small money ones don’t.

In case you haven’t picked up the theme of this post – your broker can make money whether you win or lose – as long as they don’t mess up their risk models!

They only type of trade that could cause problems are winning short term scalpers (i.e. people who trade in second/minute timescales). Scalpers who consistently lose are no problem; the broker can simply collect their money. Winning scalpers are a problem as they make money, but their trades can be too fast to hedge against. Brokers will tend to be hedge against the net positions of many tens or hundreds of people rather than the positions of individuals. Winning scalpers are a nuisance as their trades are over before the broker’s risk model will decide to hedge the trade. Some brokers (such as FuturesBetting) are happy to have scalpers – this is because they simply hedge all trades which means they don’t need complicated risk models in order to make a profit. They can just make money off the spread for each trade.

Interest

A broker with tens or even hundreds of thousands of clients will have a lot of liquid cash. What do they do with it? You might think that they are using it to place your trades. In many cases they aren’t. When you are ‘trading’ all you are doing is playing their internal market which lives in their own computers. No money is leaving the broker. It is only when they need to hedge trades that real money will be used by the broker.

For most of the time your money will sitting in their bank account earning them interest. Some brokers will pay you a small amount of interest back but most of it is going into their profit. In IG Group’s results for the financial year ending on 31st May 2008 they recorded £10.2 million in income received in interest from client balances! The year before it was £6.5 million.

Other charges

You broker may make a small amount of money through miscellaneous charges.

Charging you for withdrawing money from your account. This will hardly be a big earner. Most people will never withdraw money from their account! If anyone who works for a broker could let me have some stats for what percentage of people withdraw money from their accounts I’d love to have them.

Innactivity charges. Some trading firms will start charging you if you don’t use your account for a long time. Not a big money spinner but it adds up if they have a lot of clients who have given up on their accounts but not bothered to withdraw the remaining funds.

Education. Many companies will have training courses which you can sign up for. Some will be free but others will be charged for. Probably not a big money spinner but it means the training sides of their companies can be self funding (or even make a profit), rather than costing the company.

Conclusion

A broker needs to make profit and all the evidence suggests they are very successful at doing this.

The need to make money off all their clients explains why they sometimes terminate the accounts of people who don’t make them money (i.e. winning scalpers) – this is simple business sense.

Of course in order to make money off you doesn’t require you to be a losing trader – as long as their back-end software is doing its job they will make money whether you win or lose. In fact good brokers will welcome winners as they will regularly be placing trades, and so the broker will keep getting their all important spread and commission.

In short the broker never loses. Unless they are really bad, in which case they won’t last long!


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