The Forex market will always be unpredictable and will result in either profits or losses for the traders. Hence, traders are always required to take necessary measures to avoid making excessive losses such as using stop losses. Brokers on the other hand also take precautionary measures to protect their traders. They provide negative balance protection which is discussed below.
What is Negative Balance Protection?
A negative balance in Forex is where losses exceed the account balance of a trader and negative balance protection is how brokerage firms protect their traders from losing more money than their account balances. It is a precautionary measure taken by the brokers in case of unexpected market movements or when the market moves against the traders’ positions with a potential of the traders being stopped out. This prevents traders from owing brokerage firms money.
In January 2015, the Swiss National Bank made an announcement that it would remove the fixed exchange rate between the Swiss Franc (CHF) and the Euro (EUR). This was an unexpected move that resulted in a sudden drop in EUR/CHF which caught many traders unaware. This led to traders getting negative balances in their accounts and some brokerage firms went out of business. There was also uncertainty by the traders on whether the brokers would pursue them to recover the negative balances.
From the daily chart above, you can see the effect of the Swiss National Bank announcement on EUR/CHF in January 2015.
How Negative Balance Protection Works:
The crisis in January 2015 brought about the need for negative balance protection. Financial regulators came up with regulations to protect traders against such risks. For example, the Financial Conduct Authority (FCA) of the United Kingdom came up with a guideline that if brokerage firms were not going to offer negative balance protection or stop losses, they should cover their risks using their own money. These regulations have transferred risk from the traders to the brokers.
To mitigate the risk, brokers have set up margin calls to alert traders in case of a potential negative balance. A margin call occurs when a broker requires a trader to deposit additional money into the account in case the account balance has decreased below a certain point. Brokers usually set the margin calls as percentages. For example, if the margin decreases to 30%, the broker may alert the trader to take appropriate action.
The trader may either close their losing trades or add more money to increase their margin on the trade. If the trader fails to take any action, the broker will close the trades on their behalf to avoid an occurrence of the negative balance.
What do You do to Protect Against Negative Balance?
To protect yourself against the risk of negative balance you need to:
• Set up a stop loss. This will help you avoid making huge losses in case of an unexpected price movement.
• Use Correct Leverage. This may either work for or against you. High leverage increases the potential for high profits or losses. Therefore one should be careful when selecting leverage.
• Volume/Lot-size. You should trade the number of lots that carry the risk you are able to accommodate.
Advantages and Disadvantages of Negative Balance Protection
The advantage is that the trader is protected against the risk of loss by a negative balance since the brokers cover that risk by setting up margin calls.
The disadvantage is that a trader may be stopped out just when the market is about to move in the direction of his/her trade. Another disadvantage is increased brokerage costs to provide the negative balance protection.
Negative balance protection has proven to be very important for traders in mitigating risk. It is therefore recommended that traders should select brokers that offer negative balance protection for their clients.