Learn the importance of negative balance protection in this comprehensive guide where you will also find a list of online brokers that offer negative balance protection.
Brokers with negative balance protection
How does the fluctuation of a currency pair affect the currency pair?
To explain the importance of trading with negative balance protection, it is best to use a concrete example. The foreign currency pair GBP/USD is taken as a sample. On 2 November 2017, according to the Bank of England, the pound fell by 0.9%, around 120 pips (percentage in points or price interest points, which is the minimum possible change in the value of a pair). Is this a very significant change? It depends:
For a tourist
If you are, for example, a tourist, the fall in the pound will affect you practically nothing, because the difference between an exchange rate of 1.313 or 1.325 (which is the variation that generated the fall) is minimal.
For a Forex broker
But what if you are a Forex broker? Then things look different. For professional Forex traders, fluctuations of as little as 1 pip (which occur daily) can have a big impact.
This is especially the case with brokers who allow leverage, i.e. the amount actually traded is much greater than the amount actually invested. Leverage can be as high as 1:300, which means that for every pound or dollar that has been placed in the trade, the client, for all practical purposes, is affected (both in terms of winning and losing) as if it were 300.
An example of how the fluctuation of a pair affects a Forex broker: let’s imagine that someone has initiated a trade on GBP/USD, with an initial margin of £1,000. At a rate of 1,325 (and with 1:300 leverage) he would actually be exposing £397,500 (1,325 x 300).
Now the pound falls and goes to £1,313, so you would be exposing £393,900 (£1,313 x 300). That’s £3,600 difference (397,500 – 393,900), considerably higher than the original deposit.
And now a real case: in 2015, the Swiss franc shock caused private traders trading CFDs (contracts for difference) with leverage to lose large amounts of money. One of them had a leverage of 1:400, with a margin of 2,800 euros. Suddenly, news broke that the Swiss National Bank had abolished the minimum exchange rate of 1.20 Swiss francs to the euro. It was all so sudden that Forex brokers had no time to react. This particular trader lost around 280,000 euros, which, without leverage, would have been 700.
What is negative balance protection?
You, the reader, are probably wondering when we are going to talk about protection against negative balance. Patience has paid off, everything I have written so far was meant for you to understand perfectly. You will see:
The example given above (and other similar episodes) caught the attention of financial regulators, who put on the table some proposals to change the regulation around CFDs and leverage, with the aim of protecting inexperienced traders.
Thus, BaFin (the German Federal Financial Supervisory Authority) and CySEC (the Cyprus Securities and Exchange Commission) removed the obligation to make an additional payment on CFDs, which, for practical purposes, transferred the balance risk to the CFD provider or forex broker.
The broker was also allowed to make a call to the trader to either correct the negative balance by increasing the margin on the trade or close the trade within a specified period of time. If the trader does not opt for the first option, the broker will close the trade at the price specified on the platform at the end of the grace period.
However, it may happen that the change in price occurs very abruptly and there is therefore no time to make that margin call. When this happens, and if the broker offers true negative balance protection, he should take responsibility for the losses himself, not the trader.
Advantages of negative balance protection
Obviously, the main advantage of choosing a broker that offers negative balance protection is that the trader will never be responsible for losses that exceed his account balance. It is the broker who assumes this risk and, logically, will make the margin call – where possible – to protect itself against this risk.
Disadvantages of negative balance protection
One of the disadvantages is the conservatism that can mark the trade. That is, if the trader decides to close the trade after the time has elapsed, it may happen that the trade is closed just before the markets swing in favour of the trader. If this happens, the trader will suffer some loss, when he could have made a profit. However, the call should always give the opportunity to make a decision.
Another disadvantage is that brokers offering negative balance protection obviously have higher fees than the others.
The disadvantages also include a common complaint from brokers, who argue that the removal of the obligation for additional payments makes traders much more daring (and riskier behaviour), as they will not be the ones to bear the full losses.
- Social Trading
- Scalping Trading
- Hedging Trading
- Demo trading accounts
- Fixed spreads
- Variable spreads