Forex trading limits in the currency markets
Forex daily trading limit is the maximum amount, either up either down, that exchange-traded security (currency pair) is allowed to fluctuate in one trading session.
The price of a security like a stock or currency that is traded will change daily depending on a number of factors like political, economic news, demand, the supply of the currency and other factors. In some cases, large dealers and traders may attempt to manipulate the price of the security to maximize their profit. Hence to curb the manipulation in the foreign exchange (forex) or other securities market and make it less volatile, limits are set by the exchange or the regulatory body. Usually, for forex, the forex trading limits are specified by the central bank for the particular currency.
After the daily trading limit is reached for the specified currency, further trading will not increase or decrease the exchange rate beyond the limit which is specified. However, it may be possible to continue trading at the exchange rate limit which has been reached. The market which has reached the trading limit is called a locked market. Alternately the market status is limit up or limit down if the upper or lower price/exchange rate limit has been reached respectively. When trading resumes, the next day, the new limits will be set, based on the previous close.
The exchange rate for a particular currency affects the economy of the country, the exports, and imports for the country. Hence the central bank of the country is usually responsible for deciding the limits to control the volatility of the currency of the country in the forex market. In the United States, the Federal Reserve is the central bank of the country. The central bank has currency reserves, and it will ensure that the forex rate for its currency remains within the desired limit by selling or buying currencies, by altering the composition of the currency reserve.
Though these efforts of the central bank will make the currency less volatile, and reduce the manipulation of the forex rate, it could lead to overvaluation or undervaluation of the currency. Also, the limits imposed on daily trading can adversely affect the valuation of the asset, the currency. There are usually fundamental factors that affect the value of the currency, like the demand for the currency for paying for imports like crude oil. However, if limits are imposed on the forex rate by the central bank, the currency may not reach its real value, and it may become a mispriced asset.
Reasons for imposing limits
Limits reduce the impact of extreme volatility on the exchange rate for a currency. Often certain political and economic events or news can lead to panic selling or purchasing of a particular currency, resulting in a large increase or decrease in the forex rate. The exchange rate is important for the economy, since a large number of business transactions, especially the value of imports and exports, will vary depending on the currency forex rate. Hence the central bank of the country will usually try to ensure that the increase or decrease in forex rates remains within reasonable limits. This will also ensure that large companies do not manipulate the rates to maximize their profit
Disadvantages of trading limits
Some market analysts, experts and traders are of the opinion that there should be no limits on the forex rates for currencies. They believe that the market participants should determine the forex rate, price of the currency, in a free market. They also claim that these restrictions may be misused by some of the market participants to manipulate the market and make a profit. The ease of manipulating the market depends to a great extent on the trading mechanism used by the exchange, and simpler mechanisms are easier to manipulate.
The daily limits imposed on securities trading are important for those trading in currency and other securities. Forex traders should be aware of the limits for forex rates so that they can make the right decision and reduce the risk of forex trading. These limits help to reduce the volatility in the forex markets which have lower liquidity, and where there is more leverage. In the forex market, the central bank of the country will usually set the limit for the variations in the exchange rate for the currency of the country, since the exchange rate can affect the economy of the entire country.