Congressional oversight? Now, bringing that up is downright rude and impolite. Shame!
What Is Price Shading?
Before we get into the details of price shading, it is important to remember some background information regarding the forex spot market.
The forex spot market is an interbank market. Banks trade with and among each other. Therefore, prices are created according to the bids and offers of the largest and most liquid banks in any one particular currency. This type of trading is neither regulated nor available in a formal exchange such as a stock market. Therefore, the spot forex market is also referred to as an over-the-counter market. (For more insight, see The Foreign Exchange Interbank Market.)
The interbank prices of currencies are displayed as streaming prices on terminals, such as Reuters or Bloomberg. All the major banks, hedge funds, forex traders and multinationals use these prices to trade with each other. (Learn about the forex market in our Forex Market Tutorial.)
Brokers have accounts with one or more of the banks; they have access to the price offers and bids and can trade directly with the banks. However, brokers usually do not offer the same price that they receive from the banks to their retail customers. Instead, they mark up the price to include a profit for themselves.
Brokers have to make a profit, too, and some go even farther by "price shading," which is the practice of adjusting their prices to gain an advantage over their customers.
How Do They Do It?
First let's look at what a broker usually does. In general, brokers will receive a series of prices from the banks with which they have accounts and then will fix prices based on the aggregate prices they receive. This is the price they offer to their customers, once they have added a margin for themselves. So, for example, if they receive a price of 52 – 53 on 41 when trading the euro, it means that their bank will sell them a euro for $1.4153 or buy it from them for $1.4152. If the broker wants to offer this trade to a retail customer, a margin will be added and the broker will offer to sell it for $1.4154 or to buy it for $1.4151 - a three-point spread. Many brokers offer a fixed spread such as this.
Shading the Price
Some brokers will assess the order flow coming in and might determine that there are many more customers interested in the buy side than the sell side. Because this order flow is from retail customers - and they tend to be wrong - the broker will adjust this offer to charge a little more to all the buyers. This will bias, or "shade", the spread to 1.4155 on the offer and 1.4152 on the bid. Thus the buyer pays a little more and the broker increases profit. The broker believes that the market will sell off and, therefore, will accept the risk of shading the spread.
If there are 100 buyers and 100 sellers, the broker makes one pip on each trade, for 200 pips total. But, if there are 150 buyers and 50 sellers the broker shades the price to two pips for the 150 buyers and no profit for the 50 sellers. This results in a total of 300 pips profit. (Learn more about finding a broker in Forex: Wading Into The Currency Market.)
Detecting Price Shading
The only real way to tell if a broker is price shading is by having a terminal from Reuters or Bloomberg or dealing with a broker that provides "straight-through processing." You could also open an account with two brokers, one with a dealing desk and one with straight-through processing. Typically, dealers that provide straight-through processing do not have a dealing desk and instead charge a commission, such as 50 cents per $10,000 traded, instead of manipulating the spread.
This will allow you to observe whether a broker is consistently higher on the buy side of the interbank rates or consistently lowers on the sell side of the interbank rates. (There are three types of commissions used in this market. Learn how to get the best deal in How To Pay Your Forex Broker.)
Beating a Broker at His Own Game
Price shading does not have to be a total negative for traders. It may seem that your broker is being unscrupulous, but you can use his practices to your advantage. For example, if you can detect that your broker's pricing is consistently biased to one side or the other, it is usually because the majority of the orders coming in from retail customers are biased to one side or the other, creating an order flow imbalance. Because the majority of retail traders are usually wrong, there could be an opportunity to trade against the bias by selling, if the bias is on the buy side, or by buying if the bias is on the sell side. By going against the bias you would also be going against the majority of the other retail traders. If they are mostly wrong, you will be mostly right.
In addition, because the broker has moved the spread to disadvantage the majority of traders, which in the above example were buyers, your broker will have created an advantage for the sellers, who will then be able to enter their positions at a better price than if the broker didn't shade.
The broker also stands to lose if the market goes in favor of the buyers, but generally the broker knows what he is doing and the traders don't. If you have a broker with a dealing desk and you can detect a shading bias in his pricing policies, look out for the bias and trade in the opposite direction. You may just be able to beat the broker at his own game. (Before entering this market, you should define what you need from your broker and from your strategy. Check out Getting Started In Forex.)
Shading Vs. Slippage
Finally, don't confuse price shading with slippage. Slippage is a phenomenon of fast markets and poor liquidity. If a market moves really fast, you may not get filled at the price you see quoted because by the time your order has hit the market, the price may have moved away from where you thought you were going to be executed. To overcome slippage, use limit orders or place your order between the spread. The downside is that you may not be filled if the market moves away from your order. Sometimes it is better to pay the slippage but get the position. This is a personal judgment call. (Read more in What are the rules for placing stop and limit orders in forex?)
Get a Cream-of-the-Crop Broker
When it comes to price shading, the best way to come out ahead is to do your research well. Check out many brokers so that you clearly understand their commission structures and how they get paid. There is no free lunch. A broker is in the business to make a profit, just like you. Try to find a broker whose business practice is transparent and straightforward, but don't be too greedy - you have to pay a commission in some form or another. If a broker says he is not charging a commission, ask yourself how he is making money. Better still, ask the broker directly and always read the broker's documentation. You can also check out the forums and reviews. A good broker's name is like cream - it will always rise to the top.