So what is leverage anyway ? Leverage is simply the ability you have to open up positions with “borrowed money” from your broker so that smaller changes in the exchange rate between two currencies represent a higher gain or loss to your account. For example if the EUR/USD exchange rate was 1.5 and you had no leverage you would need to invest all your money and have the rate go to 2.0 for your profit to be around 30%. However the same is true about your risk, you would need the rate to drop to 0 before you lost all your money and a drop towards 0.5 would still mean you have 30% of your money. Effectively leverage increases your ability to profit from small movements, for example a 1:100 leverage means that the broker is representing 100 times the money you put forward in the market meaning that your money is affected by the exchange rate as if it was 100 times larger. This means that you would need just a change of 0.005 for your profit to be 30% in the above example. This also means that a move of 0.015 would wipe your account.
Right now I tell you that I do not believe in conspiracy theories and I honestly don’t think that the aim of the NFA is to remove leverage because the US government is not getting a tax cut from forex brokers (whcih they do get) or because people are running away from stocks, etc. The truth is that 90% of retail forex traders or more lose their whole accounts in trading and the NFA is responsible for investor safety so there is something wrong going on here if there is an investment option in which traders are losing money like if it was gambling. The NFA is responsible for this in some way. Effectively limiting leverage does make losing your money much harder since you require much larger movements to wipe you out. These gives traders more time to trade and will inevitably reduce the mortality rate in the forex market.
Now some people will say that it is not the responsibility of the government to protect people from their own decisions, if people want to risk their money in forex trading then let them, it is their responsibility to assume the risk. Well, by that logic we might as well legalize Ponzi schemes, don’t you think so ? The fact is that most people are losing money, therefore there needs to be a protection mechanism to avoid this.
However there is of course a negative side to this leverage reduction which most traders are pointing out. Eliminating leverage does effectively eliminate flexibility in the sense that only longer term position holding becomes a viable way to produce income (without investing more capital). Of course, people who scalp or day trade will find this measure detrimental to their trading since the current movements will only allow them to get a fraction of the profit they used to get for the same money. They will efectively have to increase their account sizes by a factor of 10 if they want to keep making the same amount of income trading the exact same way. This of course makes access to day trading harder with larger funds required but the inherent risk as percentage of capital is reduced tremendously.
The immediate consequences of changes of leverage will be immediately apparent. Traders will have to change to long term position holding if they do not have enough capital to carry on day trading. People who want to day trade will need to put forward ten times more capital and the combination of these two facts will inevitably reduce the number of losing traders to a fraction of what it is today. At least in US brokers. However people who open one position at a time that risks only 1-2% of their capital on larger market movements don’t need to worry about this. For example, if you are currently trading 0.02 lots for a 2% gain on a 1000 USD account (200 pips) you are currently representing 2000 USD in the market which means that with 1:100 leverage you are only using 20 dollars to effectively represent this position. With 1:10 leverage you will use 200 USD, so the fact is that current traders trading like this will have no problem with the changes in the rules.
Of course, the very bad side of the story comes when you realize that 100:1 and 200:1 leverage is still offered outside the US so people will massively move accounts to off shore brokers in order to have the ability to preserve their current trading style and capital requirements. This will lead to people wiping their accounts in off shore accounts rather than US based accounts and this will be absolutely disastrous for the US forex industry. I think that less than 10% of the current forex account holders will stay in US brokers if such a change in leverage takes place. It is obvious to me that limiting leverage will have the sole effect of destroying the US forex business since trader protection will be offset by the fact that US traders will need to move to non-US brokers.
However the NFA also thought about this and along with the NFA rules there is also a part which stipulates that in order for non-US brokers to admit US customers they will have to comply with NFA rules so chances are that most non-US brokers will also stop accepting US customers or limit leverage to 1:10 to US customers to comply with these rules for people from the US (this is how I interpret it, if any of you disagree please leave a comment !).
I believe that this conjunction of rules will definitely reduce the number of losing traders in the US, however it will certainly increase the capital requirements and demand a change of trading style from current US forex retail traders. However you have to think about how many people benefit and how many people will take a hit from the NFA regulations. It is clear that 5-10% of traders will find these rules bad for their trading (forex brokers too) while 90% of retail forex traders will find that the rules effectively allow them to preserve their capital better.
To sum it up, I strongly agree with the fact that high leverage is the chief technical cause of people losing their money quickly in the forex market and that a world wide leverage limitation is likely going to put a stop to the majority of these loses. It will not mean the end of the forex business (although brokers will have a lot less customers) and it will indeed decrease the number of people who lose their money quickly in a tremendous way. However I bet some of you are day trading and strongly disagree with these measures because of the consequences they bring to your personal trading. Make sure you leave your opinions and we’ll make up an interesting discussion !
If you would like to learn more about what I have learned in automated trading and how you can also learn how to program and design your own long term profitable trading systems please consider buying my ebook on automated trading or joining Asirikuy to receive all ebook purchase benefits, weekly updates, check the live accounts I am running with several expert advisors and get in the road towards long term success in the forex market using automated trading systems. I hope you enjoyed the article !