How does a Retail Broker Make Money?
Let’s look at hypothetical brokers, that hold average trader accounts of $1,000 up to $1,000,000….
If they would only make money off commissions and spread, what they obviously do, this table shows you what they would earn per trader when they charge 2.5% commission/spread on any 1%-max-risk-trade.
Can a broker make money off a person who trades reasonable with a $1,000 account? Over a year, let’s say you’l make 300 trades, so the broker makes $75. Trust me, no broker would be happy with that.
A broker has to pay technological equipment, an office rent, salaries and marketing costs to acquire new clients (to replace the blown-up clients). There are obviously different models of brokerage and there are brokers with different kinds of $average accounts that they hold for their traders.
At the bottom are CFD/Forex Brokers, then come regular stock/futures/options brokers with minimum deposits of around $2,000 and the ladder goes up to prime brokers who only accept a million-dollar minimum.
Now how do brokers make more money off clients with slimmer wallets?
1. OTC Gain
Brokers divide their traders into two categories: winning (~10%) and losing (~90%). The losing traders are useful for the broker to take the other side of the trade, profits from this contrarian risk taking goes into the market making profit. This is by no means evil, it’s just logical.
2. Financing Turn
The broker can borrow money for your margin positions from a bank and then lend it to you with a higher interest rate. Swaps and overnight financing costs differ from broker to broker as you will notice with CFD/Forex Brokers. That is because they get different interest rates from the partner bank.
Conflict of Interest
As a rule of thumb, a broker wants a client to make them at least $100-$300 per months. By only charging commissions this business model starts to make sense with $50,000 clients who make about 1 round turn (open and close of a trade) per day.
What I didn’t consider here is that most traders risk more than 1% per trade with less money than $100,000 in order to make more percentages and cash. Therefore, making the broker game easier and letting him profit more from smaller accounts short term. The chances of a blowup (more than 45% in losses) increase the more risk percentage is taken per trade (see picture in the beginning).
What can you learn from all of this?
- If you want to be a trader who trades reasonable amounts of risk (1% per trade) and want to have a trade count which is not considered overtrading (not taking low quality trades in between) you better have an account size of at least $100,000.
- If you can’t afford that, you have no other option then to run into a broker who incentivizes you to take more positions by making it hard for you to hold overnight, leaving you with no proper trading education and providing you lots of leverage. 1:30 after ESMA regulations in Forex, 1:100 still anywhere in Asia and not to forget scammy things like binary options (really stay away from them).
- You need to have super trading skills to not blow up when taking higher percentage risks than 1% and playing the “90%-loser-clients-CFD/Forex-broker-game”. The broker won’t help you acquiring them in a safe environment.
- You need to do the opposite of what the broker wants you to do, which is taking less leverage than they offer, trade less and use more sophisticated models and tools than what they offer you in free seminars (for example advanced statistics, real futures level-2 data and volume, professional coaching -> there is no “something for nothing”, all of these things cost reasonable amounts of money).