Why retail traders are more at risk of losses in current market environment

There is a looming fear of recession across Europe. The ongoing war in Ukraine has caused food and energy shortages which have contributed to inflation that has led to interest rate hikes in major economies. 

According to the European Central Bank (ECB), the harmonised consumer price index across Europe, also known as inflation sits at 8.6 per cent and this is undesirable as the ECB’s target is two per cent. This high inflation has had a toll on the Euro currency as the EUR/USD exchange rate has fallen below $1.

In June 2022, major indices like the S&P500 crossed the bear market line of 20 per cent after falling 23.73 per cent from its previous 52 weeks high, FTSE 100 has also fallen 5.6 per cent from between January and June 2022

As inflation bites harder and S&P500 and FTSE underperform, volatility indicators like the VIX is at 27.22 indicating higher than normal volatility. 

Although volatility presents retail traders the opportunity to make profits since there is a sharp rise and fall in the price of securities, it also exposes them to risks of loss. 

The fate of retail traders looks gloomy when we consider that many traders are inexperienced. A good number of them are newbie traders who started trading recently. 

Even for experienced traders, periods of volatility require tact and skill. These are the major risks which can magnify the losses for retail traders.

Excessive use of margin

Margin trading involves borrowing money from your broker to trade. It entails depositing an amount of money called initial margin and then borrowing the balance from your broker. Margin trading is allowed at most retail brokerages.

Margin grants you leverage and traders like to trade on a margin because it increases trading power and profit. But it also amplifies losses. 

For example if you want to buy EUR/USD currency pair because you think the Euro will strengthen against the dollar in future, you can choose leverage available with your broker. 

Assuming you opt for a 30:1 leverage (which is the maximum leverage allowed on currency CFDs as per ESMA guidelines) it means to initiate your order, you need to deposit an initial margin in cash of 1/30 the contract value while he loans you the balance. If contract value is $100,000 then you have to deposit initial margin of (1/30 x $100,000) = $3,333 while broker loans you $96,666.

However, if the market moves against you and the exchange rate falls by say 3 per cent, you lose (3 per cent x $100,000) = $3,000 and you can see that your initial margin capital of $3,333 has almost been wiped out.

Going by the above calculation, if you had used a lesser leverage of say 2:1, and the currency still goes against your position by three per cent, you would have still lost $3,000, but that would be six per cent of your capital, compared to loss of over 90 per cent capital in above example.

Most brokers offer high leverages to attract retail traders, but as a result of the European Securities & Markets Authority (ESMA) regulation on brokers, the maximum leverage for trading in Europe is between 30:1 for currency CFDs to 2:1 for CFDs on volatile assets. The ESMA also has a 50 per cent margin close out rule which means once your margin level falls to 50 per cent your positions will be closed by your broker. 

However some traders opt for brokers in overseas jurisdictions and island countries who offer them higher leverage, and lower margin close out requirements. By doing this, they risk heavy losses if the market moves against them. 

Leverage is a double-edged sword. It can work for or against you. In this period of high volatility, going for lower leverages or no leverage can reduce risk. 

False breakouts 

Timing the market is an act of relying on predictions to move your investments in and out of the financial market or from one asset to another. Traders time the market to know when to get into the market and when to get out.

Traders use support and resistance levels to time the market. A support level is considered to be a price level from which an asset will not fall below over a while. A resistance level is a price level an asset does not go above over a while. 

Most retail traders use support and resistance in their trading. When the price of an asset goes below the support level, many traders have strategy to enter a short position (begin to sell). When stocks go above the resistance level, they begin to buy more assets. This method of trading is called breakout trading and it employs the use of market trends. 

But extremely high volatility in today’s markets amd uncertainty regarding energy prices, inflation and many other geo-political events make timing the market more risky as there can be a lot of false breaks and trends which trick traders into losing funds. 

Attempting to short the market

Shorting can be done through borrowing stock from your stockbroker or through contract for difference (CFD).

Firstly, a CFD is a contract entered between you and your broker where the profit made is the difference in the opening and closing price of the underlying asset. With CFDs, you do not own the asset but you can profit or lose by speculating the rise or fall of its price. Most CFD brokers allow you trade CFDs on various instruments such as equity, fixed income, currency, and commodities etc. and thus it has a wide appeal amongst retail traders. But this is not without risks.

In theory, CFDs can let you benefit from falling prices and this is shorting the market.

For example, you predict the stock price of a stock which are currently selling for €200 will fall so you approach your broker and enter a short position CFD contract for 100 units of its shares. Unfortunately, the price rises to €220, and you close the position, and make a loss of €2,000 without actually owning the stock. 

For example, you believe the shares of a stock which is selling for €50 will drop by five per cent, so you borrow 100 units of shares and sell them in the stock market for €50 each. 

Unfortunately, the price increases by 5 per cent instead and it now trades for €52.50 so to exit your position, you may have to re-buy and return to your broker at a higher price of €52.50; thus losing €250.

Shorting the market presents the opportunity for profits from the fall in the price of underlying assets but that's just one side of the coin. It also presents the risk of unlimited loss should the price of the asset keep rising and your broker calls on you for more margin payment. 

This is extremely risky, and many traders lose when shorting. This can also trigger a short squeeze as it happened during nickel trade on LME and caused billions of dollars of losses for short sellers. 

Interest rate hikes make bond trading risky

During periods of inflation and market volatility, traders usually resort to bonds for safety. But as ECB tries to fight inflation by increasing interest rates, the bond yields increase. Bond yields and price have an inverse relationship, so as the yield increases, the price drops. 

The drop in the price of fixed-rate bonds is caused by increased interest rates and this is because traders will shun older bonds that pay lower interest rates to invest in newer bonds that pay higher interest rates. 

Interest rate hikes also mean that companies that issue corporate bonds could default on their coupon payment. This is because these companies now experience larger overhead cost and are paying higher interest on loans needed for expansion. In general this can affect their profitability and some may declare bankruptcy. 

A bond issuing company could also purchase another bankrupt company and the resulting merger could mean the company becomes highly leveraged and it could default on coupon payments. This will cause those trading its bonds to lose money as the bonds become less desirable.

Today interest rates are being increased by central banks and bond traders should tread with caution as these are perilous times for fixed income instruments like bonds.

Attempts to tame inflation might cause recession

Inflation, increased interest rates, and an increase in the price of commodities are signs of an impending recession. A recession is a widespread decline in economic activities. Europe is in the frontline of Economic shocks as a fall out from Ukraine conflict. 

Major industry players in Europe have sounded a warning on recession if the US doesn’t hike its interest rates slowly and if Russia stops supplying gas to Europe.

However ECB president Christine Lagarde has played down recession fears; “If the inflation outlook does not improve, we will have sufficient information to move faster. This commitment is, however, data dependent,” she is quoted as saying. 

However sudden interest rate hikes can cause a recession so equity traders with long positions who have purchased stocks hoping to sell when the price appreciates, may be at risk of losing. This is because the price could continue to decline if a recession begins. 

Risky environment for retail traders

The financial markets are risky. Investing as a whole for long-term is risky because there is always the tendency of losing. But the risk is even higher for short term retail traders, who are not investing for the long term & are also using margin to increase profits, because leverage amplifies risk.

Traders would have to take up the responsibility of self-regulating yourself & not use margin, in order to control risk in current volatile market conditions.

Disclaimer: The information provided in this article is being provided solely for promotional purposes and should not be construed as investment, tax or legal advice.