The Forex Broker Conflict of Interest: Why Your Stop Got Hit

If you have made a trade and put a stop loss only to see the price hit your stop and then reverse, you are not the only one. People everywhere are wondering the same thing: Was this by strategy or was this a coincidence? This is not an easy question and actually has many layers that you will see when you discover how the foreign exchange industry operates.

How Do Forex Brokers Earn Money

Most people assume that Forex Brokers earn their money through the Bid/Ask spread alone. This is partly correct, but the truth involves way more than that.

You can categorize Forex Brokers in two primary ways:

• ECN or STP brokers pass your orders to the market and earn through commissions. Their conflict of interest is usually lower than a dealing-desk model.
• Market Maker brokers take the other side of your trade. They may benefit when clients lose, although many brokers also hedge part or all of their exposure.

This is how we start to see the conflicts of interest of the brokers. In a market-maker model, the broker may have a stronger financial conflict than in a pure agency model.

If you are using a broker, you may be unaware that you are potentially using a market maker broker. These types of brokers do not provide details about their operating model.

What Is Stop Hunting in Forex?

In Forex, stop hunting occurs when the price moves to a level of sitting stop losses, triggers those stop losses, and reverses. Those people who get stopped out watch the price of the Forex instrument move in the direction of their original trade just seconds after being stopped out.

There are two methods in which stop hunting is done.

Natural Stop Hunting by the Market

Stop hunting is better described as liquidity seeking. Stops often cluster around obvious levels, such as round numbers, prior highs, prior lows, support, and resistance. Larger players may infer where liquidity is likely to sit, but they do not necessarily have direct visibility of every retail stop. From their perspective, a large number of retail traders will place their stop-loss orders just below a support level or just above a resistance level.

After pushing price to the support or resistance levels to capture liquidity, the market will subsequently reverse. As a retail trader, you are likely part of a group that is often targeted. This practice is entirely legal and structural; large institutional players simply require massive pools of counterparty liquidity to fill their own large positions.

Broker Manipulation

This is a more direct approach. Unregulated and some offshore brokers will requote stop orders or leave gaps to hit your stop loss. This is a common market manipulation strategy.

There is a big difference between the two, and a major reason why natural stop hunting is part of legitimate market practice, and broker manipulation is fraud.

Liquidity Providers and the Hidden Web

Retail traders will be unfamiliar with the term “liquidity provider,” but they are the firms behind the prices you are trading. They are large banks and financial firms that provide the bid and ask prices to the brokers.

Some brokers will route orders to liquidity providers based on rebate or revenue-sharing arrangements rather than based on which provider will give you the best execution. In some cases, a broker may actually get paid to send your order to a specific provider. You never know, because the only thing you see is the execution on your order, which you assume is correct and fair.

This is another example of the conflict of interest on the part of the broker. A broker is supposed to send your order to the market at the best possible price, but may have a financial incentive to do otherwise.

What To Look Out For

• Widened spreads occur just ahead of important news and remain wide longer than they should.
• Slippage that always goes against you, never in your favor.
• Frequent requotes of a fast-moving currency pair.
• Your stop loss is triggered by a few pips just before a significant price shift occurs in the opposite direction.

None of these examples, taken individually, clearly demonstrate a certain broker’s malpractice. However, the occurrence of all of them should be alarming.

Why This is an Issue?

Stop-loss hunting is a prevalent problem in this market. There are real and structural reasons that this keeps happening to most retail traders.

Brokers employing a dealing desk model have access to your stops, as you input them directly into their system. An unethical broker can see where your stops are and can manipulate the market in order to hit your stops.

This kind of behavior does not apply to all brokers. Most are honest, regulated firms, but a dishonest minority does exist, and that minority is a serious problem in the industry.

What You Can Do About It

Unfortunately, you cannot stop the bigger players from running your stops in the market. Instead, you should attempt to protect your money from dishonest brokers.

You should take the following steps to protect your money:

• Place your stops away from obvious levels, such as round numbers and the highs and lows.
• Select a broker from a country with a strong regulatory environment, such as the UK, US, or Australia.
• Review your broker’s execution policy and ensure the broker is an ECN or STP broker.
• Look at the spreads during major news events and ensure they are in line with your broker’s normal spread.

You should take the steps above to improve your broker choice. Traders who switch to better-regulated brokers often report fewer questionable stop-outs, which suggests broker choice can make a real difference.

Conclusion

There is a potential conflict of interest in the Forex industry, and most retail traders don’t properly consider it. Regardless of the challenges retail traders face, such as the divergent goals of brokers and liquidity providers, retail traders often find their stop losses trapped right in the middle of these conflicting corporate interests.

While it is not necessary to live in a state of paranoia, you should be careful. Be aware of your opponents, the different methods of income, and the final destination of your orders. This information gives you an advantage over the rest of the people in the industry when you go to place your trade.