How to Trade Around the New ESMA Rules

How to Trade Around the New ESMA
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The European Securities and Markets Authority has issued new rules recently, which greatly impact Spot FX, CFD and Binary Options transactions for European traders. Many retail traders are worrying about the transition and what this will mean for their trading habits. If you’re not trading in the EU, great! But nevertheless, in this article we shall prove that while the new rules are rather strict, they should not impact your trading habits unless you were overtrading or using excessive amounts of leverage.

Product Intervention Powers

Ever since the FX Probe in 2013, regulators have found more and more excuses to wrap financial markets in red tape. It can’t be helped: regulators are passionate about control. The new ESMA rules limit leverage to between 5 and 30 times the amount a trader has as a cash deposit in his trading account, depending on the volatility of the asset. This is less than the 50:1  limit in the USA, and much less than the previous limits (200:1 or 400:1). Here are the precise rules:

  • 30:1 on  major currency pairs;
  • 20:1 on major indices and gold
  • 10:1 on commodities excluding gold
  • 5:1 for shares
  • 2:1 for cryptocurrencies
  •  A margin close out rule on a per account basis. This will standardise the percentage of margin (at 50% of minimum required margin) at which providers are required to close out one or more retail client’s open CFDs;
  • Negative balance protection on a per account basis. This will provide an overall guaranteed limit on retail client losses;
  • A restriction on the incentives offered to trade CFDs; and
  • A standardised risk warning, including the percentage of losses on a CFD provider’s retail investor accounts.

ESMA is justifying their intervention based on  “significant investor protection concerns” in relation to spot FX transactions, CFDs and Binary Options, given their complexity, the availability of “excessive leverage” and their lack of transparency. ESMA cites  studies by national regulators have shown that between 74 and 89 per cent of clients lose money on these products.

I find myself in agreement with 3 steps that ESMA took: leverage reduction (although I would have stopped at 50:1 like the NFA) the removal of binary options (which really are coin-flip and have no connection whatsoever to proper trading behaviour) and the negative balance protection. Binary options have often been used in boiler room scams, so I agree on that ban. And most solid brokers offered a negative balance protection before the SNB-disaster in 2015 – so it’s just a blast from the past.

Bad Habits are Hard to Remove

You’ve heard it said many times: the high degree of leverage available can work against you as well as for you. Unfortunately most people never learn. Back in the broker days, we would routinely see clients opening up accounts with €500-€1000 and proceed to open up huge (notional) positions compared to their account balances.

Why? For the usual reasons:

  • the desire to make tons of money quickly
  • no real respect for the risk involved in trading
  • treating the markets like a casino
  • etc…

This bad habit (opening a micro account and attempting to swing for the fences without any interest for how the markets actually work) has been a distinctive characteristic of retail traders for ages, despite the efforts of brokers (amongst all people) illustrating very clearly that:

  • traders that use higher leverage have lower win rates (I have seen retail folk using 5-10 pip stops on huge positions trying to scalp a few pips here & there, and obviously they are forced to liquidate their positions based purely on noise);

Source: Daily FX

  • traders that have larger account balances (hence more free margin in their account to weather the storm) have better results overall;

Source: Daily FX

Based on the behavioural pattens of retail traders, I’d expect ESMA’s rules to have the following effects:

  • online Poker & betting will probably see an inflow of clients that can no longer seek their fortune with their €50 accounts;
  • retail traders that continue to seek instant gratification will most likely receive margin calls more frequently, but that won’t stop them from trading (clients of mine, back in the day, wouldn’t stop trading with a margin call – they would simply reload the account and start over);
  • retail traders that have more realistic expectations will evidently lower their position sizes and continue just like before;
  • professionals (& traders with experience) will see no change.

Margin  Explained

The ESMA is basically protecting the common retail trader from himself. Now traders will be required to deposit more capital into their accounts, and will be forced to take smaller position sizes. At the end of the day, brokers may actually enjoy this change because they shouldn’t experience as much churning of the client-base. Traders should “last longer” and might learn a thing or two in the process – hence continuing to trade and pay spreads to the brokers.

I think it’s worth revisiting the basics of Margin rules anyhow, just to see how tight the new ESMA rules are. Let’s start from the basics: your trading account should be seen as the sum of 2 components:

Initial Margin + Maintenance Margin

Let’s imagine we have a $10.000 account, and wish to go long 1 Lot of EURUSD.

Initial margin is the amount required by your broker as a “security deposit” when you open a position. The amount is calculated as a percentage of the notional value of your position (1 lot or 100.000 in our example). Previously all you needed was 0.5% (200:1 leverage) of 100.000 which was $500. So that would leave you with $9500 as maintenance margin, which is the amount of money you can lose before you reach a margin call.  With the new ESMA rules, you will need 3.33% (30:1 leverage) of 100.000 or $3333. You now have only $6666 left in your account as maintenance margin.  If you have at least this amount (of initial margin) available in your account, then you can open this position.

However, as soon as you open your position, with the new ESMA rules, you face another requirement. Your account must never drop below initial margin + 50% of the initial margin.  I believe this is what the ESMA means by “50% margin requirement rule”. So in our case, instead of just needing $3333 to keep the position open, we need $3333 + $1666 = $5000 to  keep this position open.

The question becomes: how much volatility can my account sustain, before I receive a margin call?

Each EurUsd pip is worth $100 USD = 133 AUD at current prices.

We have $5000 of maintenance margin left in the account so 5000/133 = 37 pips. With a move of only 37 pips, we will receive a margin call. Note that 37 pips is less than 50% of the average daily movement of the EURUSD currently, so there is a very high risk of receiving a margin call in this scenario.

Clearly, 1 Lot is too large a position to hold with a $10.000 account.

I may be wrong with my interpretation of the ESMA rule, but the name of the game, in the markets, is to never lose all your risk capital. Trade at such a size that you can fight back from a string of losses without fretting. Trade at such a size that allows you to open multiple positions and have enough margin to tolerate  the natural ebb & flow of the market.

Lower Frequency, Higher Probability

The main suggestion for you is to add a quality filter to your trading model – if you don’t already have one. The systematic group would call it a “signal threshold”, which ignores any trade that doesn’t reach a certain quality value.

Your account growth doesn’t depend on how active you are. Your account growth depends on the frequency and the magnitude of your winning trades compared to the frequency and magnitude of your losses. If you can learn to trade less frequently and only bet on “grade-A” setups, you shouldn’t encounter any margin problems at all.

Of course, before trading with real money you should have a viable model in the first place.

Over to You

Sustainable trading habits will never put your account in danger. Be selective with your trades and you will avoid correlation issues and margin issues. Risk 1% of your account at the very most per each trade and you will avoid unreasonable drawdowns. Keep your focus on the process, not on the money. Remind yourself that consistency and longevity are the keys to success.

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