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Should Retail Investors' Leverage Be Limited?

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What they found

In 2010 the CFTC cut the maximum leverage U.S. retail forex traders could use from 100:1 (or higher) to 50:1. Using account-level data from a social trading platform covering U.S. and non-U.S. traders, the authors compared the affected traders with unaffected ones. The leverage cap reduced trading volume by 23%, reduced average losses, and improved traders' returns by about 18 basis points per month, mainly because it stopped the highest-leverage traders from destroying their accounts. It also reduced market makers' profits from retail flow.

See it drawn

Original diagrams for the ideas on this page. Illustrative, not real market data.

Margin and leverageA small deposit controlling a much larger position, and the point at which losses trigger a margin call.Position you controlnotional value $100,000your margin deposit: $5,000$100,000 / $5,000 = 20:1 leverageYour deposit absorbs every dollar of loss$5,000$2,500$0Equity leftMARGIN CALLequity has fallen to $2,5000%1%2%2.5%3%4%5%How far the price moves against you
Margin and leverage. A $5,000 deposit can control a $100,000 position, which is 20:1 leverage. Because the loss is measured on the full $100,000, a 2.5% move against you halves the deposit and brings a margin call, and a 5% move uses all of it.

What you can use

  • When retail forex traders were forced to use less leverage, they lost less money; the leverage was hurting them.
  • The traders who used the most leverage were the ones whose performance improved most when it was capped.
  • Leverage magnifies the cost of overconfidence; the regulation worked because it limited the damage from bad trades.

Caveats

One social-trading platform, retail spot forex only, around a single regulatory event. Traders on such platforms may not represent all retail forex traders.

Tags: retail, forex, leverage, regulation

Summaries are our own reading of the paper, not the authors' words. Educational only, not advice. Discuss it in Book Club.