*What are the risks when using a retail broker to place your trades and how to reduce them*
Welcome back to the blog and happy Friday! In this blog post I am going to talk to you about a topic that most new traders never learn about until it is too late and they have lost some/all of their precious trading capital. Placing trades on the financial markets is actually only a small percentage of what is required to be a successful trader. Analysis, psychology, risk management and infrastructure are all just as important and contribute massively to your long term success.
What is Counterparty risk?
Counterparty risk is the risk associated with the other party to a financial contract not meeting its obligations. Every derivative trade (CFD trading is common amongst retail traders) needs to have a party to take the opposite side and this is where your risk lies.
Earlier this week a follower of mine messaged me on instagram to ask for help explaining the outcome of one of his recent trades. The images below show his message to me and the trade in question which is the 0.01 lot buy position ($1 per point) on US30 which is a code used by CFD brokers for the Dow Jones Index.
As you can see, he bought 1 contract of Dow Jones CFD @ 27,160 with an initial stop loss order placed 30 points below @ 27,130. Now before I continue, this is quite an aggressive trade and reasonably high risk but none the less, the trade was entered.
Price was very volatile this week and global stock market indices sold off dramatically yesterday. Instead of being taken out fo the trade at his intended stop loss price level, his broker actually executed his order much lower @ 27,072.12.
So what happened in the case of our friend on instagram?
What he experienced was something called Slippage. This is the difference between the expected price at which a trade order is to be executed and the actual price it is executed. This can be caused my a number of issues but the two main ones are price volatility and lack of liquidity.
When levels of price volatility are high, price tends to move faster and this can cause issues with brokers executing orders. This is due to latency, speed of execution and other infrastructure limitations which unfortunately, as a retail trader, are mostly out of your control. Investment banks, hedge funds and high frequency traders spend millions of pounds each year to reduce latency and improve their infrastructure to reduce slippage costs and trading delays as much as possible.
Lack of liquidity is another common cause of slippage. If there is no liquidity at your stop loss order price or even near to that price then your order will be executed at the next available price. If there is a large lack of liquidity this can mean that slippage is increased and in the case of this trader who messaged me on instagram, the next available price was 58 points below his intended stop loss order. This meant his loss of trading was almost 3x his initial intense risk!
Important! Slippage can be both positive and negative. If you experience slippage on a take profit trade order then you will likely receive more profit than expected.
As a retail trader, the best thing you can do is find a reputable broker with good liquidity providers and a robust trading platform. Bid/ask spread, slippage and swap fees are the biggest costs of trading and it should be a conscious effort to make sure these are minimised to reduce costs and increase profitability. You will be surprised at how much money you can save by reducing your costs of trading. I have covered this topic in a previous blog post which can be found by clicking on the link below.
Better brokers with larger pools of liquidity will tend to have lower costa of trading because slippage will be reduced and spread fees minimised.
IC Markets are a regulated broker that I haver personally used for trading and their spreads are very impressive for a retail broker. The image above shows the live spreads on some major FX currency pairs as at 10:45 this morning.
What other risks are there when using a broker?
The main risk is that your broker goes out of business whilst being in possession of your trading capital on your account. This is a real risk but it is more common among unregulated brokers This is why it is very important to do your due diligence when searching for a broker.
Price manipulation is also common among unregulated, smaller brokers. They will often be trading against you and taking the other sides of your trades which lead to a conflict of interest arising. You should be aware of whether your broker is using an A-Book or B-Book to place your trades (see net section).
If your broker is taking the other sides of your trades then it could be in their interest to manipulate price and volatility and trade execution to reduce your chances of success and improve their own.
What to look for when finding a broker?
When selecting a broker to use, I believe there are 3 important things to consider.
- Are they regulated and segregated?
- Do they offer access to the markets you want to trade?
- Are they trading against you?
There are a lot of not so favourable brokers out there that will take your trading capital if you are not careful. One of the easiest ways to make sure a potential broker is legitimate is that they will be authorised and regulated by a sufficient authority. This makes sure that the broker is held accountable for their actions and most of the time you will be covered by some sort of investor/capital protection.
List of the main financial regulatory authorities:
- Australia – ASIC – Australian Securities and Investments Commission
- Austria – FMA – Financial Market Authority
- Canada – CSA – Canadian Securities Administrators
- European Union – ESMA – European Securities and Markets Authority
- Hong Kong – SFC – Securities and Futures Commission
- United Kingdom – FCA – Financial Conduct Authority
- United States – SEC – Securities and Exchange Commission
- United States – CFTC – Commodity Futures Trading Commission
Another largely important, if not critical, requirement is to make sure that the broker you decide to use keeps your trading capital in segregated accounts. This means that if the broker was to get in to financial difficulty, they CAN NOT use your trading capital to pay off their debts. This one factor alone reduces the risk of you losing your trading capital due to circumstances outside of trading losses.
It always pays dividend to check where your broker gets liquidity from and where they are placing your trade orders. There are 2 types of “books” a broker can use to place your trades.
- A Book – Your trade order is passed straight through (STP) the broker and given to a liquidity provider in the larger interbank market.
- B Book – Your trade order is placed directly with the broker and they “make the market”. If you are buying 100 contracts of Gold futures, you are buying them directly from your broker. If you lose money, he will buy them back from you at a lower rate and make money.
There are many brokers out there that have their own dealing desks and will quite often take the other sides of your trades so they will then have a direct conflict of interest in your trading success. This is because when you make money, they will lose money and vice versa.
So there we have it. Hopefully now you should be more aware of the risks of trading outside of just loss of capital through your trading positions. I highly recommend you use the tips I suggested in this blog when looking for a reputable broker that can lower your costs of trading.
I would also like to remind you that FOR THIS MONTH ONLY I am offering a 30% discount on all of my trading education packages to celebrate this blog reaching 50,000 readers. Please check out the trading education page of this site and look at what I can offer you if you want to TAKE YOUR TRADING TO THE NEXT LEVEL.
All my technical analysis is done using the TradingView platform. You can get access via the link below.
My preferred broker of choice is IC Markets. Low spreads and trading costs really help long term profitability. A link to their site is below.
FTMO Trader Funding Programme.
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DISCLAIMER: None of the information posted on this site is to be considered investment/financial advice. Trading is high risk and you should only trade with money you can afford to lose.