Managing Their Risk and Making Money.

Managing Their Risk and Making Money, we will continue our discussion on how forex brokers manage their risk and make money, here is a second example.

Example 2: Two Traders and a Broker

Let’s pretend that there are two traders: Elsa and Ariel.

They both trade GBP/USD but have different opinions on where the price is headed.

Elsa goes long GBP/USD, while Ariel goes short GBP/USD.

The broker takes the opposite side of each trade.

Remember, the broker is the sole counterparty to all its customers’ trades.

Each trader trades directly (“bilateral”) with the broker and only the retail broker.

Retail forex traders do not trade with each other.

Let’s see how Elsa’s and Ariel’s trades affect the broker’s trading book.

A trading book, or “book” for short, keeps track of all the open positions that a broker holds.

Whenever its customers trade, the broker has to take the opposite side of the trade. This causes the trading book to constantly change and “net” long (or short) positions in individual currencies to arise.

The broker must continuously keep track of its long and short positions and know its net positions precisely at all times.

A “book” is a record of all the positions held by a trader.

Retail traders may also refer to their own positions as a book, although the term is mostly associated with institutional traders.

As a trader, you have your own “book” as well. Your book is simply all your open positions as well.

Net Position

As you can see above, even though both Elsa and Ariel have open positions against the broker, the broker’s net position is zero.

The broker has a short position against Elsa’s trade but also has a long position against Ariel’s trade.

The two trades offset each other which results in the broker’s exposure to market risk being eliminated.

Assuming this is all the GBP/USD positions that the broker has on its book, its market risk exposure is zero.

Of course, the broker has to make money so it quotes a different price depending on whether the customer wants to buy or sell. We know the difference between the two prices as the spread.

In the example above, Elsa bought GBP/USD at 1.2503, known as the “ask” price, while Ariel sold GBP/USD at 1.2500, known as the “bid” price.

This means the broker’s spread was 3 pips or 0.0003 (1.2503 – 1.2500).

Basically, the broker bought GBP/USD from Ariel at 1.2500 and turned right around and sold GBP/USD to Elsa at the higher price of 1.2503, pocketing the spread.

This spread is the broker’s profit, which equals $30 (0.0003 x 100,000).

It doesn’t matter if the market fluctuates widely since the broker’s net position is zero,

The market is locked in because of the offsetting trades.

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