Leverage caps on retail Forex trading – how it impacts the Forex market

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Leverage caps on retail Forex trading has led to mixed reactions amongst retail brokers.

The use of leverage is often compared to using a double-edged sword because it can lead to extreme results on either end of the spectrum in terms of gains and losses. Since leverage amps up the movements in positions, many get concerned over the likelihood of mandatory sell orders getting triggered and possibly speeding up loss.

The Practice of Safe Leverage

“It’s safe to say that if you use leverage in a responsible manner and treat it with the caution it deserves, it can certainly be an effective tool that can produce favourable unprecedented results,’ explain experienced industry professionals from Australian forex broker comparison site, Compare Forex Brokers.

The results of leverage caps will lead to the end of your Forex account in no time. Brokers frequently offer 1:100 on your capital, which means if you deposit $1000, you can be traded up to $100K, which is 100 times your capital. On the flip side, if share prices drop a mere 10¢, that will be enough to wipe away your original $1000 capital. The golden rule is to decide what you can afford to lose before taking any risks and jumping in.

The proliferation of online trading platforms and availability of cheap credit has led to the significant growth of Forex trading by retail investors. They make use of a few safety precautions to help mitigate risks of leveraged forex trading. For starters, losses are capped within manageable limits. Strategic stops must also be made to keep those losses capped and to protect profits. And finally, they stick within leverage that’s appropriate to their comfort level.

When leverage caps are imposed, as in the US since 2010, Forex traders are expected to make themselves aware of where they fit in the respective new regulatory schemes. In addition they are expected to determine how regulators classify the counterparts that are used to trade over-the-counter Forex.

Eligible contract participants wouldn’t need to worry about restricted access to leverage, but since the Forex market is increasingly being a lot more like the heavily regulated securities and commodities markets, trading activities would need to be handled with greater caution, both in terms of operations and interactions.

Regulatory intervention in the European Union and its impact

Earlier this year, ESMA announced its decision to opt for drastic changes, which included large reductions to leverage levels, despite the majority of the trading industry advising not to make major changes to the leverage limits. Leverage limits were placed on the opening of positions by retail clients from 30:1 to 2:1 of varying volatilities:

  • 30:1 for major currency pairs;
  • 20:1 for non-major currency pairs, gold and major indices;
  • 10:1 for commodities other than gold and non-major equity indices
  • 5:1 for individual equities and other reference values;
  • 2:1 for cryptocurrencies

This action was taken due to the fact that ESMA and national competent authorities were concerned over the rapid increase in the marketing, distribution, and sale of these products to retail investors in the European Union. Its goal was to protect investors from risks including instant depletion of margins due to costs and fees; and the risk of small price movements driving significant changes in the available margin of the investor. For the first time, investors will not be able to lose more money than they put in.

With lessened leverage comes greater responsibility for brokers to be able to provide value for their clients. This may be done in the form of the utilisation of better tools, market research, and commissions transparency. Of all these, transparency may take longer to actually become a common practice, including disclosing the statistics from losing clients.

Brokers are also placed in an awkward situation, as they are left having to choose between potentially losing clients that seek greater leverage to offshore jurisdictions; or risk their reputation by engaging in legal changes to cater to the needs of traders in the European Union.

Time has yet to tell how things will pan out for brokers and traders in the European Union now that the changes have been made. When this was done in the US Forex retail industry, traders weren’t able to move offshore, as it is considered illegal under US law. As a result, many simply gave up retail trading altogether as leverage levels were implemented, while others continued to trade under the new rules and adapted to them.

Leverage caps in general are calculated on the basis of quantitative simulations and analysis. Regardless of where brokers and traders stand on such changes, they must always plan ahead as to how they would respond to it.

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