The forex market will always be unpredictable. Traders can take measures to avoid major losses, such as using stop losses. Forex brokers can also take measures to help their traders avoid big losses, such as providing negative balance protection.
What is Negative Balance Protection?
A negative balance in forex is when a trader’s losses exceed their account balance. Negative balance protection is when brokers take steps to prevent a trader’s balance from falling below zero. It prevents traders from owing them 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, catching many traders unaware. As a result, many traders had negative balances, and many brokers went out of business.
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, then 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, if 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 can 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.
Final Thoughts
Negative balance protection has proven to be very important for traders in mitigating risk. It is therefore recommended that traders should choose forex brokers that offer negative balance protection for their clients.
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