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The new NFA regulation

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Leverage on focus

Wed, Aug 12 2009, 14:02 GMT
by John Putman II

FXstreet.com

Facing the New NFA Regulation
FIRST IN FIRST OUT (FIFO)...
Hedging in the Spotlight

The NFA recently submitted a proposed rule change to the maximum leverage an FDM may allow its retail clients to use. While not as heated as the "No Hedge" debate, the proposed changes have fueled some discussion among many of the retail traders on the net. Traders who are opposed to the changes feel that the reduction will limit their opportunity for profit or will prevent them from participating in the forex market place altogether. Both of these assessments are true to a point, but there is of course another side to this coin.

While leverage does provide a potential increase in profit, it also provides an equal increase in potential risk. Beyond that, it may actually increase risk over reward due to probability shifts within a model: A trader using 200:1 leverage, who is intent on keeping single trade losses to a small percentage, 1% or 2%, will be forced to place stops so close to the entry they will greatly increase the probability of the stop being hit. This shift in loss probability can skew the models true win-loss ratio and quickly turn a positive expectation into a negative one.

While a properly funded account can withstand stops much further out from the entry and still only sustain losses of one or two percent, a trader with a poorly funded account who moves their stop outside of normal market volatility ranges will quickly find themselves loosing large percentages of capital if the market moves against them. Even in a good model with a positive expectancy, just a small run of losing trades can wipe an account out when it's managed this way. So, if a low barrier to entry consistently results in nearly 100% probability of ruin, what then is the benefit to the trader? Beyond the learning experience, in my opinion, there really isn't one. This is why the NFA has said, "...[the] NFA is concerned that higher leverage amounts can deplete a customer’s account balance — and result in forced liquidation — much faster than retail customers realize."

There is also the question of effectiveness: Will the rule change actually help retail traders preserve their accounts. I think the answer is "no". There is very little, if any, empirical evidence that accounts on average can survive trading at anything above 10:1 for extended periods of time, i.e. four to five years. The few examples that may exist are very likely exceptions to the rule and of little statistical significance when compared to the large number of accounts that actually collapse under the pressure of excessive leverage.

In the following example we look at the impact of jumping from 1:1 leverage to 10:1 in a hypothetical1. equity curve.

Model Basics:

• Objective Technical Trade Model;
• Parameters optimized over ten years of data;

The following assumptions were made with this model:

• Starting Balance was $100,000;
• Each lot was worth $100k US;
• Each Pip was worth $10 US;
• Transaction Costs were 2 pips per round turn;
• No Hedges were allowed; and
• No overlapping positions in the same direction were allowed to prevent unintended returns do to leverage.

In sample one we see significant but manageable draw-downs with leverage set at 1:1. Traders with less than optimal timing into this model would have experienced draw downs of +10% and +20% based on the parameters above, if they were trading at 1:1

In sample two, with leverage set at 10:1, we see those draw downs increase substantially. Traders with less than optimal timing into this model would have suffered complete account ruin twice had they stayed in an attempted to ride the losses out.

While these draw-down results aren’t representative of every trade model in the modeling universe, they are not unusual, at least not in my work over the last six years. Additionally, you’ll be hard pressed to find professional traders with track records of more than four our five years using leverage levels anywhere near 10:1, never mind 100:1.

So, if the new limits won't actually help traders, why make the change? In an environment of financial turmoil where brokers, banks, corporations and insurance companies have all been headline news for months, it is likely a knee-jerk reaction to political pressure to get tougher regulations in place to protect investors and traders.

Unlike the new Hedging rule though, that I think has a positive impact on traders, I feel this lacks any real substance and is more symbolic. Unfortunately that gesture that “We are working to protect traders” may force traders into less regulated environments. Additionally it will unnecessarily burden FDM’s with more programming changes that really do nothing to protect the client. At 100:1 leverage it is almost guaranteed their accounts will be wiped out after just a handful of loosing trades.

In the end I also feel the NFA sends the wrong message to retail traders who lack experience in the markets by setting leverage at these levels. A trader who has not survived the highs and lows of this market may look at the NFA’s decision to cap leverage here as a signal this is “safe” when really that is not the case.

In my opinion traders need better, objective and unbiased education; they need to understand exactly how these things affect them and they need to see real data and real world samples to make drive these issues home, and hopefully off-set some of the misinformation present on the net. If the regulators really want to help Forex Account Holders avoid the pitfalls of over-trading and excessive leverage they should look here first and avoid arbitrary rules that have no real impact and send inappropriate signals.

1. This model is hypothetical and the profits shown are not real world returns. They suffer from forward looking biases and do not properly reflect the true impact of building and exiting positions in dynamic price action. The information contained in this report is for informational purposes only; no suggestion or recommendation to trade is being made.

HYPOTHETICAL PERFORMANCE RESULTS HAVE MANY INHERENT LIMITATIONS, SOME OF WHICH ARE DESCRIBED BELOW. NO REPRESENTATION IS BEING MADE THAT ANY ACCOUNT WILL OR IS LIKELY TO ACHIEVE PROFITS OR LOSSES SIMILAR TO THOSE SHOWN. IN FACT, THERE ARE FREQUENTLY SHARP DIFFERENCES BETWEEN HYPOTHETICAL PERFORMANCE RESULTS AND THE ACTUAL RESULTS SUBSEQUENTLY ACHIEVED BY ANY PARTICULAR TRADING PROGRAM.

ONE OF THE LIMITATIONS OF HYPOTHETICAL PERFORMANCE RESULTS IS THAT THEY ARE GENERALLY PREPARED WITH THE BENEFIT OF HINDSIGHT. IN ADDITION, HYPOTHETICAL TRADING DOES NOT INVOLVE FINANCIAL RISK, AND NO HYPOTHETICAL TRADING RECORD CAN COMPLETELY ACCOUNT FOR THE IMPACT OF FINANCIAL RISK IN ACTUAL TRADING. FOR EXAMPLE, THE ABILITY TO WITHSTAND LOSSES OR TO ADHERE TO A PARTICULAR TRADING PROGRAM IN SPITE OF TRADING LOSSES ARE MATERIAL POINTS WHICH CAN ALSO ADVERSELY AFFECT ACTUAL TRADING RESULTS. THERE ARE NUMEROUS OTHER FACTORS RELATED TO THE MARKETS IN GENERAL OR TO THE IMPLEMENTATION OF ANY SPECIFIC TRADING PROGRAM WHICH CANNOT BE FULLY ACCOUNTED FOR IN THE PREPARATION OF HYPOTHETICAL PERFORMANCE RESULTS AND ALL OF WHICH CAN ADVERSELY AFFECT ACTUAL TRADING RESULTS.

Published on  Wed, Aug 12 2009, 14:02 GMT

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Facing the New NFA Regulation

Wed, Aug 12 2009, 10:43 GMT
by Alberto Muñoz

FXstreet.com

• Hedging in the Spotlight
• FIRST IN FIRST OUT (FIFO)...
• Leverage on focus

Related Blog Posts

• CMS Forex Vera Hawkin View
• MG Financial Peter Wong View
• Gain Capital Glenn Stevens View
• FXCM Drew Niv View
• GFT Forex Gary Tilkin View

• Dirk Du Toit & Dr. Sivaraman Responses to “NFA Rule: 2-43 (b) - Is US retail FX going to be ever the same?”

• NFA Regulations Webinar with Rob Booker
• New US-Specific Forex Regulations To Be Aware Of… by Steve Misic
• Interbank FX Official Statement about NFA’s Fine
• NFA fines Utah forex dealer member, Interbank FX LLC and its principal $225,000
• NFA permanently bars Foreign Trade Bank Securities Inc.
• Interbank FX Announces Compliance with the New NFA Rule
• Advanced Markets, Easy Forex, Ikon Royal & MB Trading jump above $20 mio minimum net capital
• CFTC Charges Georgia Man with Operating a Multi-Million Dollar Forex Ponzi Scheme
• Integral Is The First White Label Trading Systems Provider To Announce NFA Compliance
• FXCM launches OCO entry orders to meet NFA’s FIFO rule
• Forex.com announces not to be affected by NFA’s FIFO rule limiting Trade with Stop and Limit Orders
• GFT Announces Continued Use of Stop and Limit Orders, Full NFA Compliance
• Facing the New NFA Regulation - Laying the Pave for a New Forex Industry in the U.S.
• NFA - New Rulings Coming Along Will Change The Forex Industry Forever
• NFA takes a new step forward to set up a professional FX market environment in the U.S
• Effective Date of NFA Forex Requirements
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• NFA - Not allowing stop and limit orders
• NFA Not allowing stop and limit orders - FIFO delayed to July 31st
• NFA confirms FIFO delay to July 31st 2009
• NFA New Requirements - Stops and Limit Orders Allowed but with Important Restrictions

Related Resources

• National Futures Association: Forex Price Adjustments and Trade Practices – Proposed Adoption of Compliance Rule 2-43
• Revised Effective Date for Portions of NFA Compliance Rule 2-43(b)

Published on  Wed, Aug 12 2009, 10:43 GMT