The three main ways brokers make money with leverage
Brokers have three main ways of making extra money while offering leverage to traders.
- Trading fee = Fee charged to open and close trades.
- Spread = Spread cost between the bid and ask price.
- Management fee = Interest payment charged each day for keeping a leveraged position open overnight.
Trading fees
It is common knowledge that most trading platforms make the bulk of their income from trading commissions and spreads but in the case of a broker, these costs are increased.
If you would normally be charged a fee of 0.10% or a 5 pip spread, these costs will be amplified due to the use of borrowed money.
Keep in mind that the actual percentage of spread distance does not change, only the position size.
Since leverage gives you the ability to trade with a larger position size, the fee that goes into opening and closing the position is increased.
For example, if you deposit $1500 into your stock broker account and buy stocks for all your money and the commission is 0.15% you would pay a flat fee of $2,25.
If you add a ratio of 1:25 it completely changes the cost.
The total amount paid in trading fees would be 25 times larger, $56,25.
Spread
Spread is the difference between the bid and the ask price in the order book.
This is a standard fee that most forex brokers charge their clients for opening and closing trades and is often used instead of a flat percentage fee.
A standard spread cost is somewhere between 0.2 pips to 20 pips depending on how liquid the currency pair is.
The wider the spread, the higher the cost.
Brokers make money more money with spread costs when credit is added since the position size is typically larger than in a spot market trade.
Let’s say that you trade forex with leverage and open a standard lot worth $100,000 at a spread of 2 pips.
This would cost you $20. ($100,000 x 0,0002 = $20)
Imagine that you don’t add a multiplier to that mix and reduce the position size by 100 times.
Your spread cost would suddenly drop to $0,20.
Management fee (overnight fee)
The management fee is a flat interest payment brokers charge for keeping positions open overnight.
It has the same function as a monthly mortgage payment with the difference that it is charged every day at midnight for positions that roll over to the next day.
This is very common in crypto trading and most brokers who offer leveraged products such as futures, options, or other derivatives charge this commission.
The management fee is typically between 0.03% and 0.06% depending on the trading platform.
You can avoid paying this commission by closing out all your positions before the end of the day.
Only open positions will be charged the management fee.
How does the broker benefit from it all?
There are obvious reasons why brokers benefit from providing leverage such as increased position sizes, higher fees, and often more losing traders that generate revenue.
But other reasons are beneficial as well and they include.
- Offer more markets – Trading platforms such as CFD brokers indeed offer more markets to trade. This is beneficial because they can reach a bigger audience of traders by providing forex, stocks, cryptocurrency, commodity, metals, energy, ETFs, and much more.
- Enable smaller accounts – Most traders and investors start out small and quickly realize that it’s going to be a tough job to generate profits from a small account of $100 or even $1000. Margin-traded products help supply smaller traders and investors by adding more capital to their positions. It is of course a riskier way of investing but it is up to each trader to manage the risk properly in leveraged markets.
- Short selling – Short selling and leverage go hand in hand and this is beneficial for brokers because they can offer traders to bet on a falling market. Without margin, there would be no short-selling because the whole concept of shorting a market relies on borrowed contracts.
- Hedging – A very helpful tool that only stock trading can offer is the option to hedge. Hedging is done by taking the opposite side of a trade that you are already trading and by doing so you cancel out all risk when the same position size is used. For example, if you buy $500 worth of Tesla stock and short sell (hedge) the Tesla stock at the same time, you are fully hedged.
- Competition – Competition among brokers is as high as it has ever been. By offering brokers benefit from all the above-mentioned things and can stay competitive longer. It is also true that with these contracts, brokers can afford to lower their trading fees to stay even more competitive because they will still earn a larger income from commissions due to increased trade volume.
These are the types of brokers you should know about
The most common type of brokers are:
- STP = Straight Through Processing
- MM = Market Maker
- ECN = Electronic Communication Network
- DMA = Direct Market Access
Each type has its features when it comes to how they provide liquidity and how they match trades.
The broker you choose will either take the other side of your trade, which is the case for the Market Maker brokers.
Or, they will hire a liquidity provider that will take on all the risk.
STP, ECN, and DMA brokers do not assume the risk on their own, and in trading terms, it’s called that they don’t have their own “dealing desk”.
Only MM brokers have a dealing desk that handles all the trades in-house.
For example, if you trade through an MM broker and you make a profit of $250 while trading forex, the broker will lose on the particular trade.
If you trade through one of the other brokers, they will not lose money.
The opposite is also true, when you lose money through an MM broker, they profit from your loss.
This is the biggest revenue source for an MM broker while STP, ECN, and DMA brokers mostly rely on income from trading fees.
Why do brokers provide added capital to traders?
Brokers and trading platforms that provide leverage do so simply to earn more money.
These fees increase which is direct revenue, losses tend to be larger (which benefits MM brokers), more markets are offered so their client base is larger, and more flexible trading is offered through short selling/hedging.
The overall activity on the trading platform is also increased because the way brokers market leverage is for day traders mostly.
Imagine a trader who opens and closes 15 trades in a day with a position size of $2000 at a trading fee of 0.10%.
This would mean a total revenue of $30 from that particular trader in one day.
Now imagine a trader who deposits the same amount ($2000) but instead opens and closes 15 trades with a ratio of 1:30.
This would instantly increase the revenue by 30 times and the broker would profit $900.
This is the main reason why brokers provide leverage and you can see how these numbers quickly add up when thousands of traders trade at high ratios.
Do brokers ever lose money?
Yes, sometimes they do, but only Market Maker brokers.
Here is why.
Only one type of broker called a Market Maker broker will lose from providing leverage to its clients and this happens when traders profit.
Since Market Maker brokers take the other side of the trader’s position they are at risk of losing money every time a trader enters the market.
Suppose a trader enters the FX market with a standard lot of $100,000 and makes a +1,20% gain.
This equals a profit of $1200 for that trader and a $1200 loss for the MM broker.
This is the only time that a broker would ever lose money.
However, since most retail traders lose money on average, Market Maker brokers still make huge profits from all these losses.
How much do brokers charge their traders to borrow money?
Some brokers will sometimes charge a management fee which acts much like an interest payment on a car loan or a mortgage.
The management fee typically costs anywhere between 0.03% – 0.06%.
This fee is charged at the end of the day for all positions that are carried over to the next trading day.
Since a multiplier is borrowed money it makes only sense for the broker to charge you a small percentage as interest for borrowing their capital.
Most brokers do not provide their own liquidity and are more or less forced to charge their traders a management fee since they are in turn charged by their own liquidity providers.
Other than this direct fee, there is no other fee that brokers charge for leverage.
- Keep reading these articles for more info:
- Why brokers give leverage
- How much does leverage cost?
- Is it possible to lose more than you invest with leverage?
- Do you need to pay back leverage?
- What happens when you lose on a leverage trade?
