FIFO and LIFO Rules 2009

 

While the pages of this magazine is and always has been traditionally devoted to all aspects of trading many various markets, I thought it appropriate to inform traders of new rule changes issued by the National Futures Association that apply to currency traders in the United States. These rule changes have far reaching implications for not just currency traders but training schools, trading systems and firms that have principle offices in the United States. The traditional methods of doing business will be drastically changed as of August 1, 2009. Note that these rule changes apply only to the United States as the National Futures Association and the Commodities Futures Trading Commission are the governing bodies for the United States and lacks any jurisdiction outside the United States. What I would like to highlight in this article is first the history of the retail trader and the firms and schools that rose along with the general public’s popularity with trading. Next, I will outline the new rules recently issued by the National Futures Trading Commission and outline their implications for traders. A comparison and contrast of these new rules to the old way of trading will be highlighted so traders and all concerned can understand what these new rules mean.

The retail trader is a phenomenon inherent in the modern day since the early 1990’s. Traditionally, traders were a small group of people that worked in the industry, were well trained by a university education or were taught by an insider in the industry. The use of indicators as a means to make trading decisions was quite primitive but rose along with the retail trading public. Along came the computer, the PC that revolutionized trading for anybody interested. So trading any instrument became wholly democratized for young and old, educated or not, industry experience or not. All that was required was a computer, investment money and the ability to learn. Along with this phenomenon and a growing interest to learn came training schools, trading systems and firms to handle this growing interest. Traders were taught how to place orders to hedge, stop loss orders, limit orders, closing and opening positions and the use of many modern day indicators that arose with the computer. Many learned how to profit from  these methods..We have all grown accustomed to this normal way of doing business since the early 1990’s. The National Futures Association has now turned this modern method of trading on its head with new rules that now govern trading, particularly currency trading.

Rule 2-43 and its various lettered subsections dealt a serious blow for traders that wish to hedge a currency position in the same currency pair. No longer can currency traders hedge positions. This rule went into effect May, 2009.

Next came Rule 2-43b, the elimination of stop loss, trailing stops and limit orders, effective August 1. No longer can positions be closed by hitting the close button, effective August 1, 2009. Instead positions must be closed by an OCO order, an offsetting position. Lastly Rule 2-43b instituted FIFO, first in- first out. This means no matter how many lots a trader may have or how many points of profit, the first lot must be addressed first before dealing with the remaining lots.

Hedging and its implications. Why hedge and why is hedging so important to traders. Suppose a major economic announcement will be released imminently and you the trader don’t know which way the announcement will go based on expectations. So you implement a long and short in the same currency pair. Upon release of the announcement, your pair takes off long. So you bail out of your short position and ride your long position for a profit. If the economic release was really out of sync with expectations, you maybe able to hold both positions at the same time and profit both ways. I’ve done this countless times.  Suppose you are a swing trader and hold positions for long periods. Well you notice that on one particular day your long position will suffer an outside day  so you take on a short position to hold and profit for the day. Suppose you entered a long trade and realized you entered at the wrong point but you know the trade is a good long. Your trade position goes down so you go short so as not to miss the points and wait for your long to come back and profit. Suppose the GBP/USD approaches resistance or support but it doesn’t appear it will break at that moment so you hedge your position and profit. Suppose the USD/JPY is trading at the middle of its range and you want to take a position but are unsure of direction so you  hedge your position. Every point of movement can be a gain with hedging especially for scalpers. No longer is hedging allowed in the same currency pair under Rule 2-43b. The argument by the NFA is hedging increases fees for the firm and has no economic  benefit for the trader. The solution is to go long and short using two different accounts. Another argument by the NFA is hedging creates rollover interest for firms. and has no economic  benefit for the trader. The solution is to go long and short using two different accounts. Another argument by the NFA is hedging creates rollover interest for firms.

Rollover interest or carry interest is paid on accounts when traders hold their positions overnight. A trade that is profitable earns interest while negative positions lose interest. Not much because interest rates are so low around the world. Well hedgers may have multiple positions that may or may not earn interest and results in fees  for the firm if traders hold hedge positions overnight rarely would a hedger want to hold an unsure position overnight. As an aside, much speculation exists that oil traders will undergo the same fate to eliminate hedging. Commodity Futures Trading Commission Rule 74 FR 23964 took the hedging function away from non commercial swap traders and replaced it with “limited risk management”. Sophisticated traders would know hedging as a limit and a stop loss with prices placed at different intervals.

Stop loss orders are geared for traders that don’t scalp or sit in front of the computer all day. Normally these traders have market savvy and understanding because they know where the market is going but realize events of any trading day may disrupt their profit potential. So they set a stop loss, a point of loss they are willing to lose on a trade in case a position goes against them. Many use trailing stops especially when you have profits built into your trade. As the market goes against you, your trailing stop hits and you are able to realize your profits. Stop loss orders are not allowed anymore according to Rule 2-43b.

Limit orders. How far are you willing to ride your trade and how much profit do you want to earn. This is the purpose to set your limit on your computer. Again a function for sophisticated traders who know their market and currency pairs because they don’t have to sit and wait to exit their trade manually but increasingly used by traders of all sorts as this market has grown in popularity. Also not allowed under Rule 2-43b as of Aug 1, 2009.

Close out trades. For those not using trading systems who wish to manually close out a trade, you simply click the close button to exit your trade and take your profits or sustain your loses. No longer allowed under Rule 2-43b beginning Aug 1, 2009. Instead OCO orders will be instituted to enter and exit the market. OCO stands for One Cancels the Other. Reason for OCO orders are due to the last NFA rule called FIFO, First in, first out. Suppose you have a buy order for one lot on the GBP/USD at 4800. Now suppose your trade drops to 4700 and you place another buy order. An hour later your 4700 position is now 4750 on your second lot. You can’t exit your trade with a 50 pip profit because you must first address the first lot. You can’t take your profits because you still have a loss on the first lot. When the first position is resolved, you may then take your profits. First opened must be the first closed.

Exiting the market. Using OCO orders allows traders to exit the market using OCO entry orders as long as the entry is in the opposing direction. Suppose you are long the GBP/USD at 4800 and you wish to exit at 4900. You enter a sell at say 4600 and take your profits. OCO is linked so when you enter to take your profits, the sell order is automatically cancelled. OCO allows a trader to link any pair, any price and any amount. OCO orders will be the governing orders for entry and exit for currency traders in lieu of  stops, limits and closing position windows. The new FIFO rules just don’t allow for these positions any longer.

I guess the next question is why the revolution and why currency markets are affected. This answer must be twofold.  The number of complaints and enforcement actions investigated and ruled upon by the National Futures Association and the Commodity Futures Trading Commission against currency trading firms is enormous. Many firms don’t register with FINRA or the NFA, others don’t segregate their accounts, others violate anti money laundering laws and bank secrecy acts, some charge enormous spreads, principles just disappear with their firms money and others rig the main trading computer. The list and complaints are endless. Currency trading is traded in the over the counter market so a certain buyer beware scenario must be evident because of the unregulated nature of this market.

Secondly, its very explicit in the writings and communications of the NFA and CFTC that the general public is just not smart or sophisticated enough to understand such complicated financial instruments nor can they have the capacity to trade and profit from such instruments. So they instituted these protect thy customer rules. But only in the United States do these rules apply. While legitimate firms have abided by many new and various policies such as increased  capital requirements from $15 to $20 million, prompt account statements and frequent audits, actions by NFA still follow under the protect thy customer rule. Yet the NFA knows from their prior explicit communication and policy statements that regulating this market is quite impossible so why not regulate traders. So can the regulating authorities treat the currency market as a regulated futures market by instituting orders the same as futures orders and eliminate the profit motive and drive traders away from the business of trading currencies. Remains to be seen.

 

What these rules mean for firms is a complete retool of their computer systems that will take time. Increasing the capital requirement for firms may help drive out the many corrupters of the industry and give the respectable firms the name they deserve.

Trading system designers must  retool their systems as well to comply with new rules. Training schools will have to teach new methods of trading.

One aspect of the currency markets is prices never remain the same for any length of time. At times these markets will look chaotic to the novice because of the fast movement of prices. But it is this fast movement of prices that gives the currency markets their organization and traders ability to profit from price discovery. A true method does in fact exist for traders novice or pro to profit. Now more than ever exists education upon education for traders to learn these markets, to learn indicators, to learn various currency pairs and how they move and the mechanical aspects of this market. Its in every firms interest to help traders become successful. This they do through education. Novices are encouraged to stay away until ready.

Because of the recent proposal of the Farm Bill in Congress, the CFTC will have the ability to regulate Forex traders if passed.

Traders should be aware of other proposals that may affect their markets such as carry interest that could be treated as ordinary income. Hedge funds that may see more registration, more reporting requirements and compliance costs. Forex traders that manage accounts may have to pass a test and face higher costs. Speculation exist that margin requirements may be decreased for Forex traders eliminating further the profit objective. Our markets are currently in flux and facing a revolution so traders must be aware of enforcement actions by regulating authorities and legislation proposed by our government.

 

July 2009

 

Brian Twomey is a currency trader and Adjunct Political Science Professor at Gardner-Webb University.

 

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