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November, 2018

It's been 3 and a half years since our last intervention in this column. Too many. Here we could enumerate a long list of reasons and excuses for this long absence, but the reader is not interested in our justifications. He wants the useful information that can be used in trading currencies. We have already pointed out that this section does not claim to report the daily news; the intention is to emphasize the news that have a global significance, for a long time. We hope that the prolonged pause will not happen again and that we will succeed in our goal of updating these pages several times a year. Below we will take care of the new rules regarding Forex, that is, those that the European commission has imposed on brokers.

The institution that imposes the rules and simultaneously monitors the securities and capital markets is called ESMA (European Securities and Markets Authority). In May of this year, ESMA introduced the new rules that mainly concern the relationship between brokers and "small investors", as indeed we are, that trade with currencies mainly through the Internet. The new regulation is effective from August 1, 2018. The purpose of the new rules is to protect retail investors. The limitations described below do not apply to customers who have a professional level. Let's see the new rules and let's comment together.

Prohibition of Binary Options

For those who don’t know this "financial instrument" (after you will understand why the name has been quoted), here is a brief explanation. The investor chooses a currency pair (or the shares of a company), defines a period of interest and decides if after this period the value of the pair will increase or decrease. There are only two options and that's why it's called binary option. Very simple and it is mainly for this reason that it has become very popular. Regarding the length of time, you could also choose one minute. In fact, it is a pure bet, almost entirely tied to luck, especially for very short periods, those that attracted more greedy investors, wishful to make big profits in no time. The investor bet a certain amount of capital and the broker, in the case of the positive outcome for the client, paid him between 50% and 90% of the "invested" amount. It is very clear that this way of "investing" is in fact a kind of gambling. About 90% of retail customers were losing money.

The main reason for this restrictive measure lies in the conflict of interest between the broker and the client. The financial intermediary assists the client in financial transactions and by definition has the same interest as a client, that his client draws profit from his investment. Even if the broker always gains on the difference between the selling price and the purchase price, the aim is also to make the client profit that in this way will be happy with the service received and will remain faithful for a long time, guaranteeing a continuous profit to the broker. This symbiosis misses for binary options because the broker gains only when the customer loses and therefore his interest is contrary to that of the customer. We fully share this prohibition and we believe it has arrived with a considerable delay. We have never dealt with binary options and have never promulgated this financial tool.

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Regarding Forex, before seeing the new novelties introduced, we underline one aspect. The new legislation speaks of the contract for difference (CFD). Formally, all of us who trade with currencies don’t fall into the Forex trade, but under the CFD. The main difference, which is negligible for our business, is that the operations we perform are not necessarily performed in the Forex market, but it’s a contract between us and the provider that provides us with the service and guarantees the same conditions as the real Forex market.

Leverage limitation

For couples of currencies consisting of 6 major currencies, the maximum leverage that a broker can offer is 1:30, which means the minimal margin of 3.33%. Before this new legislation there was no prescribed limit and some brokers also offered an unreasonable ratio of 1: 2000, i.e. it was enough to invest only 0.05% of the total investment. For couples where at least one of the two currency that make up the pair is not one of the main ones, the leverage is further limited and can not exceed 1:20. This limit also applies to the main stock exchange indices (NASDAQ, S & P 500, DB Italy 40 and so on) and gold. The regulator introduced this differentiation because it believes that the volatility of the majors is lower than the others, and therefore less risky for investors.

This limitation is an excellent measure for small investors. Many are disappointed because the magnitude of potential profit is limited, but they forget that in this way they are much more protected from loss. Even the leverage of 1:30 is very risky because with an unfavorable change of 3.33% all the capital invested is lost. In the graphs with the trend of the currency pairs we can find many examples where this value has been reached and exceeded in very short times, even in a single day. We believe that the 1:10 leverage is a good compromise between profitability and the risk of loss.

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Limitation of the Stop Loss

ESMA has introduced a limitation on the Stop Loss to 50% of the amount invested. This measure was introduced with a good intention to protect "small investors", to limit their losses, but the measure is also debatable. The "defense" of the position, when the trend is against us, is an important strategic element. If we trade with the 1:10 lever, with 50% of the amount we can defend the negative trend of 5%. It often happens that this limit is exceeded and that it comes to lets hypothesize to 7%. With 100% of the capital we would be able to cover up to 10%, which means that in this case we would be covered by a good margin. Fortunately, this limitation can be avoided. During the opening, the 50% limit must be respected, but after that we can increase it by adding capital to our position. For example, by investing 100 euros, the maximum loss block is 50 euros. After the opening, we can correct the position by adding another 100 euros and increase the Stop Loss to 100 euros. The 50% limit is respected, but in this way we have almost halved the leverage and we had to have additional financial means available, which is not always the case.

Further risk warnings

For years, there has been a rule for financial service providers to warn customers about the riskiness of the financial instruments being offered. This time the legislator went a step further and now obliges the providers to announce the percentage of customers who have lost capital during the last 12 months. In the various Forex platforms, you will find the different percentages, always very high, ranging between 60% and 80%. The main reason for these high numbers is high leverage. With the new rules, this percentage should be significantly lowered.