Price Shading Demystified
Price shading is a relatively common practice carried out by Forex brokers.
Since it involves the artificial manipulation of "market" prices, it’s something that all serious retail Forex traders should pay attention to.
In this article, I’ll explain what price shading is, how it works, and how you can use this information to your benefit.
The OTC Market
The first thing to keep in mind, is that the Forex market is an over the counter (OTC) market, which means that technically, there is no such thing as a “real” price.
In the Forex market, prices are first derived from the Interbank market where banks like Goldman Sachs, UBS and Deutsche bank (among others) trade currencies according to their own needs.
In doing so, the supply and demand for currencies determine the Interbank currency prices at which banks trade with each other.
When trading through your retail broker, you’re not actually seeing the Interbank prices. What you’re seeing is actually an aggregate price determined by the broker, plus an additional 1-4 pip spread, depending on the currency pair.
As you probably know, the pip spread is essentially the fee that your broker charges for their services.
Forex Broker Pricing Example
To go through an example, let’s say the EUR/USD is trading in the Interbank market at the price of 1.0955-56.
Your broker will then markup the price by 1-2 pips. So the price that you’re trading will be something more like 1.0955-57.
What Is Price Shading?
Price shading is a common broker practice that adds another cost layer temporarily (in real-time) on top of the pip spread.
The broker does this when there’s a big imbalance between the buyers and sellers of a particular currency pair, because when too many retail traders are positioned on one side of the market, the broker is exposed to a large loss if the Interbank price moves in favor of the retail traders.
Thus, the broker “shades” their prices by increasing the pip spread to compensate for the increased risk that they face.
Later on, as the retail buyers and sellers start to balance out, the broker reverts their prices back to normal levels.
How Price Shading Works
In order to balance their risk, the broker will charge retail traders slightly more on the side of the market that begins to look “heavy”.
So instead of quoting 1.0955-57 to retail traders, the broker might quote them 1.0955-58.
The traders who take trades on the long side thus have to pay a little more compared to the sellers.
Why Brokers Price Shade
On the surface, it may seem like brokers shade their prices solely to benefit themselves at the expense of their customers (i.e. retail traders).
However, we also have to consider that brokers’ primary means of revenue is via the charging of spread fees. That’s their core business model. As much as possible, brokers don’t want to risk their capital by speculating on market prices.
Thus, it makes sense for them to charge more (on the side of heavier demand) to balance the potential losses they face in the event of runaway market prices.
Also, consider that in a capitalistic society, brokers have the incentive to lower their spreads in order to compete for business with other brokers. Thus, even though brokers do occasionally participate in price shading, there's a practical limit to much they can (temporarily) raise their spread fees.
So for the most part, I don’t consider price shading to be particularly unethical or unfair.
This being said, it doesn’t mean that retail traders are completely helpless. Armed with this information, you are now in the position to make better trading decisions.
Detecting Price Shading
The most accurate way to detect price shading is to compare the price spread directly from Bloomberg or Reuters terminal with the spread that your broker is charging you.
However, since you probably don't have access to those terminals, one way you can detect price shading is by comparing your price feed against a Straight Through Processing (STP) Broker, which makes money by charging you a commission and not by marking up the spread.
Another rudimentary thing you can do is to watch closely for times when your broker is consistently widening its spread on one side of the market.
Dealing With Price Shading
For the most part, there’s little that retail traders can do to stop the industry practice of price shading.
We can’t control what brokers do, but we CAN control how we trade.
Here’s one way to look at it:
Since price shading typically happens within a few minutes, one way to avoid this is to simply trade on the longer time frames. The longer your trading timeframe, the less price shading will affect you.
What you you think about price shading?
Let me know in the comments below.
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