The CFTC Margin Rule: What it Means for US Investors
Today, we will take time to examine the rule established by the Commodities and Futures Trading Commission (CFTC) on leverage and margin requirements for individual forex accounts in the US.
The concept of margin and leverage is one that is not well understood by the majority of the trading public. Lack of understanding on the use of leverage and margin is a major cause of the inappropriate allocation of capital to trades. This usually leads to overexposure in the market and compounding of losses when trades go bad.
Leverage is a part of the modern day financial market, and leverage is what allows individual traders to trade forex. What is leverage? Leverage is simply the use of borrowed funds to control larger positions or initiate larger trades than the trader’s account capital can ordinarily handle. Without leverage, a trader will typically need to fund his trading account with at least $US3 million, just to be able to trade a single Standard Lot. Now if the markets were to function fully without leverage, less than a fraction of 1% of individual traders would be able to access the forex markets for the purpose of trading.
Historically, the issue has never really been about the availability of leverage, but more about the abuse of leverage by traders. It is not uncommon to see some traders trying to double their trading account in one day. The only way of attempting to double an account is to increase the lot sizes of trades beyond what the account capital can carry, and this invariable leads to trading losses and margin calls.
It was in an attempt to curtail such practices especially with the global markets still reeling from the effects of the global financial crisis that the CFTC came up with the new margin requirements for individual forex and options trading accounts operated in the United States.
The CFTC Rule
The CFTC rule on margin mandates individual traders to maintain a leverage of 1:50 for forex accounts and 1:20 for options trading accounts. This means that for every $100,000 trade contract (1 Standard Lot), the trader is expected to put up a margin collateral of $2,000.
It is universally accepted in the world of financial trading that traders should not commit more than 5% of their capital on any single trade. Anything beyond this is overexposure, and overexposed accounts are extremely susceptible to margin calls because any losses incurred are not only magnified, but difficult to recover from. If a trader is to go by the 5% rule and intends to trade Standard Lots, his account must be funded to the tune of at least $40,000. Of course there is an option to trade mini-lots, but what is most pertinent here is that traders who use US brokers will need more money to trade than their counterparts in other parts of the world.
Utilizing the CFTC Rule to Your Advantage
In order to benefit from the CFTC rule, you need to properly understand the concept of leverage and margin. The rule is actually meant to protect traders from themselves, and keep them within the confines of acceptable risk management. Many traders have the tendency to over trade and put themselves in multiple positions without having any control over any of them. This practice is what leads to margin calls. But with the CFTC rule, traders cannot use too much leverage or overexpose their accounts with multiple trades. This enhances their chances of recovering from any losses sustained in the course of trading.