September 9, 2011 at 12:00 pm | 12 comments

A Crash Course about the Forex Market Structure and Forex Hierarchy

The craze for Forex trading in many parts of the world is beyond imagination. As people look for alternative ways to make money in the face of dwindling incomes and disappearing jobs, more people are discovering online Forex trading as a potential way of making “easy” money. In some countries, you can hardly walk into three streets without seeing some form of Forex-related advert. This situation is not helped by the glittering adverts you see on some websites and financial TV stations, where Forex is depicted as next to picking dollars from the street.

Back in the day, I remember the Biology classes about the food chain. The food chain actually showcases the realities in almost every human endeavour. There will always be a few on top, living off the multitude below. Pareto called it the 80-20 principle.

The same holds true in Forex. While 95% of individual traders consistently lose money, some players in the Forex market who constitute the top 5% are smiling all the way to the bank. Many would-be traders do not know that the entire structure of the market tilts the scales in favour of the BIG DOGS (brokers and institutional traders). If you want to outsmart these guys and bank in pips into your account regularly, you need to be on top of your game and you need to understand the Forex market structure and Forex hierarchy.

Forex Market Structure

The Forex market is made up of three classes of players:

1. Brokers (dealers and market makers are included here)
2. Institutional traders e.g. investment banks and high net-worth investors like Warren Buffett and George Soros
3. Individual (retail) traders

1. Brokers

If you go to any Bureau de Change to change your local currency to a foreign one and vice versa, you will notice that there is a difference between the price at which you buy a foreign currency with your local one, and the price at which you exchange a foreign currency for your local one. This difference is the profit made by the Bureau de Change operators on the transaction. The same applies to online Forex trading.

Currencies and other online-traded financial instruments have two quoted prices: the BID and ASK price. For example, a quote of Euros to US dollar is expressed in this way:

EUR/USD= 1.3480/1.3483 (Bid/Ask)

The difference between the BID and ASK price is the SPREAD, which in this case, is 1.3483 – 1.3480 = 3 pips. For some currencies, the spread is as much as 50 pips. The value of the spread is determined by transaction volume. Anytime a trader opens a trade position, the SPREAD is instantly and automatically deducted from the trader’s account.

It does not matter if a trader makes or loses money in that trade; the broker ALWAYS walks away with his money.

Just do the Maths and find out how much Forex brokers make IN A SINGLE DAY from spreads of millions of traders. One more, not all Forex brokers are honest with traders. So I recommend to read article:

• Forex broker scam: How to identify one using my tips

Only you can choose the broker, so make the right decision.

2. Institutional Traders

Financial institutions by virtue of their operations have a large pool of funds running into billions of dollars, from where they can easily hire a team of experienced trading experts (some with more than 25 years experience). In addition, they can access premium news services from Bloomberg and Reuters, which deliver the news about five before it gets to individual traders. This service costs thousands of dollars a month, effectively priced out of the reach of most retail traders.

The profits of this group of traders are effectively derived from the 95% of retail traders who lose money in Forex, and this number is swelling by the day.

In Forex, a winning trade somewhere is usually at the expense of another trader who held a contrary (and hence a losing) position in the market.

You can only receive when someone else gives. So a trader can only receive profits when someone else gives away the profits (that is, suffers losses).

3. Individual Traders

Lack of proper training and inexperience causes 95% of traders in this category lose money. Their losses pay for the buildings, the cars, the fat salaries and the end-of-year profits of financial institutions and other successful traders! Of course, whether they make profits or losses, their spreads go to the brokers…naturally.

So at the end of the day, the individual traders who lose money trading Forex only end up servicing the top 5% individual traders, the brokers and the big dogs (the financial institutions). A perfect food chain setup!

So while the Forex market structure looks like this:

The Forex market hierarchy is more or less like the food chain:

So as a trader, you have to decide to what point in the hierarchy you want to belong.

Once you have made that decision, you have to commit yourself to acquiring the right knowledge and tools to climb up the Forex hierarchy, which is where this blog will help you out.

For instance, read fresh article about how to choose a Forex broker using a rating system and individual reviews.