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 traded will change daily depending on several 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 security price 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 country’s economy, exports, and imports. Hence, the country’s central bank is usually responsible for deciding the limits to control the volatility of the country’s currency in the forex market. In the United States, the Federal Reserve is the central bank of the country. The central bank has currency reserves. It will ensure that the forex rate for its currency remains within the desired limit by selling or buying currencies by altering the currency reserve composition.
Though these central bank efforts 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 asset’s valuation, the currency. There are usually fundamental factors that affect the currency’s value, like the demand for the currency for paying for imports like crude oil. However, if limits are imposed on the central bank’s forex rate, 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 a particular currency, resulting in a large increase or decrease in the forex rate. The exchange rate is important for the economy since many business transactions, especially the value of imports and exports, will vary depending on the currency forex rate. Hence, the country’s central bank 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 think that there should be no limits on currencies’ forex rates. They believe that the market participants should determine the forex rate, price of the currency in a free market. They also claim that some market participants may misuse these restrictions to manipulate the market and make a profit. The ease of manipulating the market depends greatly 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 to make the right decision and reduce the risk of forex trading. These limits help reduce the volatility in the forex markets, which have lower liquidity and more leverage. In the forex market, the country’s central bank will usually set the limit for the variations in the exchange rate for the country’s currency since the exchange rate can affect the economy of the entire country.