"When you talk about trading, chances are that you will most likely focus on the markets that you are trading, perhaps a bit of trading systems and the fundamental and technical analysis. Traders often think that their job is done after they have placed their trades. But did you know that there is a whole different operation behind the scenes? Have you wondered what happens after you place your trade? Who fills those trades and how they are executed? This article gives you the basic foundation that you will find useful at later stages. Not all forex brokers are created equally. The way your trades are executed is just as important to your success as a trade as your trading strategy. Learn about the different ways your trades are executed and also the pros and cons of these two basic forex execution models. Do not make the mistake that most other beginners in forex trading do, which is to ignore this very concept of trade execution."
As a trader, the most likely things that will matter the most to you is how well you execute a trade and whether you are consistently making a profit. But besides this, there are other things that you should be aware of.
Many beginners to forex trading tend to ignore the concept of understanding how their trades are executed. This is partly because of the misconception that as long as the trade is filled, there is nothing more to talk about.
The truth is further from it. Knowing how your trades are executed can give you insights into the costs of your trading and also identifying potential loopholes in the market. For example, did you know that some brokers don’t allow you to place a limit order unless it is a few pips away from the market price?
Or for that matter, did you know that some forex brokers don’t allow you scalp (day trade) the markets when there is a major economic news release? Do you wonder what the reasons are behind these rules that seem so trivial?
If you hang out at any forex forum, chances are that you will come across forex traders complaining how their profits were held back and that some were given bad price fills. What is the reason behind this?
The answer to that lies in the concept of trade execution in forex.
How are trades executed in forex?
The general consensus is that after you place a trade, it is filled by the forex broker. The way the trade is filled is that there is a counterparty who has taken the opposite side of your trade. For example, if you have an open short position (sell position) and you want to close this position, you would buy.
But the price at which you went short is the price where someone else, the counterparty, was long and vice versa.
Now when there is high liquidity in the markets, it is easy to buy and sell at the price you wanted. While the above is a basic model, the way your orders are filled can happen in two ways. The way the orders are filled is nothing but the forex execution model.
What is a forex execution model?
The forex execution model is the way your trades are filled by the broker. To understand this, let’s first explain the two models. In one model, the forex broker acts as your counterparty. This means that when you buy, they sell and vice-versa. In this model, the forex broker acts as the market maker and is the liquidity provider.
Another forex execution model is where your broker simply acts on your behalf and executes your order in a network. The network can comprise of many other forex brokers as well. Thus, with this model, your trades are passed through into the liquidity pools. In this aspect, your forex broker does not act as a market maker but works as a broker for you.
There are of course technical terms to describe the above two forex execution models. They are known as:
- Market making model
- Dealer model
What is a market making model?
A market making model, as the name suggests is a place where your trades are executed. These are done in-house by the market maker. Some mistake this as the forex broker or the market maker taking the opposite side of your trade. This is only partly true. As a dealing desk or a market maker model your forex broker will try their best to match your orders with another counterparty or trader who is trading with the same forex broker.
Only when there is no matching counterparty does the forex broker or the market maker steps in to become your counterparty. To profit from this model, the forex broker charges a spread (the difference between the bid and ask prices). This spread compensates them for the risk that they take.
What is a Straight Through Processing model?
In this execution model, your trades are executed a Straight Through Processing (STP) model. Here, the broker plugs into a liquidity pool where your trades are matched by other traders from different forex brokers.
You can see that the liquidity here can vary and depends on the number of participants. In return for providing you with this service, the forex broker charges a commission on a per trade basis. Here, there is no conflict of interest.
Which is better? Market marker or STP?
There is no saying which of the two execution models are better. There are pros and cons with both. It largely comes down to the volume of trades that you make. And your style of trading of course. A market maker will have rules such as not being able to trade around volatile news events and limitations on the minimum spread to place limit orders.
An STP model on the other hand will typically offer you variable spreads, meaning that at times you will pay both spread and fees and even here, the spread that you pay can vary.
In the next part of the article, we will explore this concepts in more detail.
