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The new NFA regulation

Hedging in the Spotlight

Mon, Jun 29 2009, 15:24 GMT
by John Putman II

FXstreet.com

Facing the New NFA Regulation
FIRST IN FIRST OUT (FIFO)...
Leverage on Focus

NFA Rule: 2-43(b)

Rule 2-43(b) effectively eliminates the ability of traders to hedge open positions. In this article we will explore the function and purpose of hedging, the details and rationale behind the NFA's decision and address some additional impacts of the decision.

Hedging - A brief overview:

The purpose of hedging typically is to shift or limit the risk associated with adverse price movements associated with an underlying commodity.

A farmer who is required to deliver corn in the fall can offset some of the risk associated with an unexpected drop in prices by initiating a hedge in the futures market. In this case the hedge provides a direct economic benefit to the corn grower by protecting a portion of the revenue he will receive for his product.

Forex Hedging - No Economic Benefit:

The NFA believes that hedging in forex provides no direct economic benefit. Their rationale for this is likely routed in the above example of our commodity producer who passes his risk off to the speculator in the futures market via the hedge.

All "traders" in the forex market who are attempting to extract profit from the fluctuations of price are speculators. Put differently, none of these individuals who are hedging are printing money in their basement (at least we hope not), so there is no risk to offset by establishing a currency hedge.

The easiest way to see the lack of economic benefit in a currency hedge is to watch the account balance once the hedge is established. The account balance becomes stagnate - not moving higher or lower. Establishing a currency hedge has the same effect as closing the open position.

This rationale can be effectively applied to every version and circumstance of currency hedging, whether the hedge be a partial hedge or a full hedge.

Interest and Transactional Impact:

In their letter to the CFTC the NFA also cited a discrepancy in the way most retail forex brokers handle the interest at the time of roll-over. They noted that while a hedged position's interest should wash out, it often doesn't and results in a "charge" to the client. If the hedge was allowed to persist long enough this discrepancy would eat significantly into any potential profit of the hedge. The NFA didn't provide any data on what the typical impact is or whether it's actually a significant impact or simply a possibility.

The NFA also noted the hedge results in additional transactional charges when establishing the second position (additional spread is paid to the broker on the hedge).

It's true there is a second spread paid, but if we go back to our previous example of simply closing the original (the single trade method), a new trade would presumably be entered at the point where the hedge was removed. This would result in the same transactional impact (less the interest rate discrepancy) as the hedge method.

One of the finer points in the NFA letter is the affect of volatility on the hedge. Depending on the leverage used in the open positions, a widening of the spread during periods of high volatility could force a margin call on open positions. This would result in the traders positions being liquidated at unfavorable pricing, causing a significant loss. It's a valid point, but it could also be argued that all traders are subjected to volatility and timing impacts and excessive use of leverage will create margin calls in non-hedged strategies.

At the end of the day, I don't personally feel hedging has any actual benefit for traders who use it, but I'm not sure eliminating the strategy will accomplish the desired result. Traders can move accounts over-seas, or by the NFA's own admission, simply open another account where the hedge activity can be conducted. This does nothing to eliminate the transactional impact, the discrepancy in the interest payment, the affects of volatility on highly leveraged positions or the money laundering activities the NFA also alluded too. If the work around to the rule is so simple, one has to wonder why it was even put into place.

Having read all the positioning for the rule, I would have liked to see some data that actually supported the statements. I think being able to show that the approach actually results in smaller profits (larger losses), more frequent margin calls, a higher rate of account ruin etc, would make it a stronger argument.

I also think it's worth mentioning the mental factor of hedging: Whether you agree with the practice or not,it's obvious that hedging, for many people provides a certain level of "comfort" within their strategy. If employing that mental safety net, keeps a trader focused it may have a benefit that goes beyond the black and white of the numbers.

So what now?

Traders who have successfully used hedging, or traders who want to use it in future strategies have several things to consider before they take their next steps.

The first thing a trader should consider is, can they live without the hedging option. It may be time to blow the dust off the Demo Account and your spread sheet software and begin to trade without the hedge and see how well they can duplicate the strategy. Getting out of the market when a hedge would go on and then getting back in when a hedge would come off; should provide an account holder with nearly duplicate results - slightly better when interest rates charges are considered. If a hedged trade feels safe - imagine how safe you'll feel when your out of the market altogether.

Trader's can also opt for opening a second account. There are some drawbacks to this, especially for the smaller retail trader who may end up with additional exposure to risk associated with leverage and volatility.

Finally, traders looking to move their accounts over-seas should throughly review the regulatory environment of the country where they are putting their money. The should also determine if there any additional tax consequences when generating profit/loss in another country. If nothing else, traders should take their time transitioning and educate themselves on their new account home.

Published on  Wed, Aug 12 2009, 14:28 GMT