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The new NFA regulation

FIRST IN FIRST OUT (FIFO)

Mon, Jun 29 2009, 15:46 GMT
by John Putman II

FXstreet.com

Facing the New NFA Regulation
Hedging in the Spotlight
Leverage on Focus

NFA Rule 2-43(b)

The NFA recently enacted Rule 2-43(b) which effectively eliminates hedging by forcing brokers to close trades on a First In First Out (FIFO) basis. The NFA has added clarification to the rule, stating that customers can instruct their broker to off-set like sized positions.

Some traders have expressed concern that the rule will negatively impact their trading outside of the obvious limitation on hedging. The position of the author is, FIFO will add a layer of complexity but should not negatively impact a traders returns.

The Multiple Strategy Trade (Trades in the same direction):

It's not unusual for traders to engage in multiple strategies within the same account; at first glance the rule would appear to hinder any strategy who's trade had been opened first. Upon closer inspection this is not the case.

Sample EUR/USD Trades: (Prices are hypothetical)

Sample #1 – Pre FIFO

Trade # 1 Long Term Strategy (Long Trade)
Entry: 1.4287
Stop: 1.4000
Limit: 1.4500

Trade # 2 Short Term Strategy (Long Trade)
Entry: 1.4350
Stop: 1.4250
Limit: 1.4475

In this example Trade #2 hits its stop before Trade #1 hits its limit. Prior to FIFO Trade # 2's stop at 1.4250 would be applied directly to Trade #2.

Trade # 2 Net P/L is:
1.4250 – 1.4350 = -0.0100 (-100 Pips)

Trade #1 goes on to hit its limit at 1.4500

Trade #1 Net P/L is:
1.4500 – 1.4287 = 0.0213 (213 Pips)

Total P/L from both positions is 113 Pips.

Sample #2 – FIFO

Trade # 1 Long Term Strategy (Long Trade)
Entry: 1.4287
Stop: 1.4000
Limit: 1.4500

Trade # 2 Short Term Strategy (Long Trade)
Entry: 1.4350
Stop: 1.4250
Limit: 1.4475

In this example, Trade #2 hits its stop before Trade #1 hits its limit. According to FIFO, Trade # 1 must now be closed out first.

Trade #1 Net P/L is:
1.4250 – 1.4287 = -0.0037 (-37 Pips)

Depending on how brokers handle the remaining stop and limit orders, this will effectively leave Trade #2 with its original Limit but Trade #1's Stop.* Trade #1's Limit could also be in limbo here.

At this point, traders should now look at Trade #2 as a replacement for Trade #1 (Trade #1 became Trade #2 when Trade # 2's stop was hit). If Trade #2 is allowed to take the place of Trade #1 and hits its limit as in Sample #1 P/L is as follows.

Trade #2 Net P/L is:
1.4500 – 1.4350 = 0.0150 (150 Pips)

Total P/L from both positions is 113 Pips.

For this to work, traders MUST remove the original Trade #2 Limit of 1.4475, otherwise they will see Net Profit levels lower than the sum of the original (Pre-FIFO) trade setup.

Once traders work through this sample a couple of times the application of switching trades will become obvious and the implementation should be relatively straight forward.

* Please verify with your broker how stops will be handled on your platform. The new rule will effect OCO (one cancels other) and traders should not assume how remaining stops and limits will be applied. Application may vary from broker to broker.

Duplicating the Hedge

The NFA's position regarding hedging is that it provides no economic benefit; this is also the authors position. The new FIFO rule eliminates the ability of a trader to hedge positions, which has a secondary impact of preventing a trader to from using multiple strategies within the same account.

Despite the limitations, traders can effectively duplicate a hedging strategy and or multiple strategies in a single account by simply getting neutral (no open positions) whenever their model would signal a hedge or new opposing position is required.

In the samples below we review the impact of an open position on a hypothetical $100,000 account. Pips won or lost are assumed to be worth ten dollars per pip. The initial position is assumed to be a Long EUR/USD entry, no adjustment for transactional impact (spread) is made.

Sample #1 – Baseline: Trades are not hedged and the position is left open through the balance of the price action.



Sample #2 – Hedged: Trades are hedged towards the end of the price action sample.



Sample #3 – Neutral: Trades are closed out when a hedge or opposing position is required.



When a trader's model would signal the end of a hedge or opposing position, they would simply reenter the market at the current price. It should be noted that this approach does not induce higher transaction costs and may actually reduce roll-over impacts that tend to favor the broker.

Published on  Wed, Aug 12 2009, 14:27 GMT