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When Black Monday comes…

A slight twist on a Steely Dan tune there. It might seem like I’m dating myself a bit with that kind of reference, but I’m actually a little bit young to have been a fan of that band back in their heyday. I did hear their music via my father’s choice of tunes, though, and developed a taste for it myself later on.

But I digress.

Twenty-two years ago today the event that commitment me to the markets took place – Black Monday 1987. I was a freshman in college at the time. I was in and our of classes, so I couldn’t exactly follow events as they unfolded, but it was pretty clear from the updates I did get that something dramatic was happening.

Two things about Black Monday were what drew me into the markets once and for all as a trader. The first was seeing the absolute bargains that stocks like IBM and Dow Chemical became because they’d lost literally half their value in that one day. I’d long been a holder of Dow stock in a dividend reinvestment plan (DRIP) so I knew about how that stock traded. The way the market cut the price by 50% made absolutly no sense to me. Had I had a trading account at the time (I was still only 17) I would have been a buyer. That motivated me to open up my first account a couple months later when I was old enough to do so. I’ve been trading ever since.

The second thing Black Monday did was really drive home for me that there was something interesting in these financial markets. I had entered college planning on pursuing a degree in computer science (I’d been programming for years), but that didn’t last. Not that I immediately decided to have a career in the markets, mind you, but I did start learning all I could about trading and the markets from that time on. It clearly put me on the path (a winding one to be sure) that I’m traveling today.

What about you? Did Black Monday have any impact on you? For that matter, have there been any particular market events which have defined or changed the course of your trading?

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Trading News

NFA Justifications and Reasoning for Killing Forex Hedging

Marjorie, who has been commenting on the No more hedging for forex traders post, dug up the NFA communique in which the reasons for the rule change are outlined from when the proposal was put forward to the CFTC after the comment period. You can find the full text here (including the part about price adjustment). I’m pasting below the relevant parts having to do with hedging/offsetting.


The other trading practice NFA believes must be addressed involves a strategy that FDMs refer to as “hedging”, where customers take long and short positions in the same currency pair in the same account. NFA is concerned that customers employing this strategy do not understand either the lack of economic benefit or the financial costs involved.

Ten of 17 FDMs surveyed offer the strategy to their customers, although for most it is a very small part of their business. Of these ten, six actively promote it on their web sites, while another one merely indicates that it is available.

Several of the FDMs told NFA that they had not offered the “hedging” strategy until their customers requested it. Although many of the FDMs admit that customers receive no financial benefit by carrying opposite positions, some FDMs believe that if they do not offer the strategy they will lose business to domestic and foreign firms that do.

NFA has two major concerns about this strategy. First, it essentially eliminates any opportunity to profit on the transaction. Second, it increases the customer’s financial costs in several ways. One way it increases costs is by doubling the expense of entering and exiting the transactions. In the on-exchange markets, a customer who carries opposite positions will normally pay twice the commissions. Similarly, a forex customer will pay the entire spread twice (buying at the high end of the spread and selling at the low end) rather than paying half on entry and half on exit.

Additionally, the customer pays carrying charges that always exceed the funds it receives. In a normal transaction, a customer receives interest on the long position and pays interest on the short position. Since the two transactions are mirror images, you would expect the receipts and payments to zero out. In practice, however, the amount a customer receives on a long position is always less than the amount a customer pays on a short position. Since these transfers occur daily when the positions roll over, the loss increases continually over time.

The costs described above are integral to the strategy, but there is an additional cost that could occur in certain circumstances. FDMs typically determine the equity balance in the account by calculating the liquidation price of the individual positions using the bid rate for long positions and the offer rate for short positions. If the customer holds contemporaneous positions long enough, the carrying charges will bring the equity below the required security deposit. Furthermore, if the bid-ask spread on the currency pair widens, as may happen when volatility increases or the FDM anticipates major market events, the customer’s account equity may fall even faster. If the account falls below its security deposit requirement while the spread is wider than normal, the account could be liquidated at unfavorable prices even though the customer has no currency exposure risk.

The strategy also creates significant potential for abuse. An FDM could promote the strategy to unwitting customers with an eye to collecting the additional spread and carrying costs. A knowledgeable customer could use it to launder money by using the carrying charge to take intentional losses. For a managed account, the practice could be used to disguise losses and inflate the manager’s performance by, for example, directing the FDM to offset a winning position and then entering into a new transaction in the same direction while letting the losing position run.

NFA solicited comments on banning the practice, and two commenters agreed with the proposal, stating that the practice serves no economic purpose. A third supported the ban without discussing the reasons behind it. One commenter that operates an institutional forex platform as well as a retail one indicated that institutional investors never use this strategy. Most commenters stated that the practice results from customer demand and generally felt that NFA should not dictate what strategies customers choose to use. Some were also concerned that customers will simply take their business to foreign counter-parties who can accommodate them.

A number of commenters argued that the practice provides a trading strategy benefit. Specifically, they argued that it allows customers to pursue both a long-term and a short-term trading strategy in the same currency. Some commenters also stated that the practice provides an economic benefit because it allows customers to maintain a directional position by lowering their margin requirements when the position goes against them. The proposed rule would not prohibit customers from pursuing long and short-term strategies in separately margined accounts, and it is not clear that the benefits of maintaining a directional position justify the costs.

Several commenters also recognize the financial costs of maintaining two positions but noted that these costs could be alleviated if FDMs treat them as a single position for calculating interest charges and allow customers to offset positions against each other when exiting both at the same time. In fact, at least one commenter seems to suggest that NFA should require this treatment. None of these FDMs have chosen to do so voluntarily, however. Furthermore, this approach would be equivalent to dictating how or how much Members can be compensated.

NFA believes that the potential for misuse outweighs any perceived benefits from allowing customers to carry long and short positions in the same currency in the same account. Therefore, Compliance Rule 2-43(b) bans the practice and requires FDMs to offset positions on a first-in, first-out basis (FIFO). It does, however, allow customers to direct the FDM to offset same-size transactions.

One commenter who supported Compliance Rule 2-43(b) said that NFA should provide sufficient lead time so that firms now offering the “hedging” strategy could change their systems. NFA agrees with this comment and will consider systems issues when setting an effective date.


One of the big gripes people have with this NFA rule change is the “nanny state” aspect of it whereby the regulators are going to protect the traders from themselves. There’s definitely a fair bit of that in here. I did, however, find the parts about avoiding abuse by money launderers and those running managed accounts interesting. Having seen some really deceptive ways people promote trading systems I can definitely see how a money manager could use hedging to create an illusory performance record.

All the parts about increased transaction costs are well known and have been discussed at length, so there’s no need to dwell on that again. The one argument that the NFA did include, though, was the potential for a situation where a customer could get margin called on a hedged position because of an expansion in the spread. This is something which can only happen to a trader who is running at basically maxed-out leverage, but definitely does present the potential for broker abuse.

Aside from that, I think the most telling line in the whole justification is this: “…many of the FDMs admit that customers receive no financial benefit by carrying opposite positions.” The brokers themselves are saying that hedging doesn’t actually benefit trader performance at all, but being good business people they are giving the people what they want.

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Trading News

Failure to Track Your Trading Could Cost You Millions!

There’s a story on the Bloomberg site today with the title MF Global Told to Pay U.K. Trader About $30 Million. It details a case where an account manager misled a day trader into believing that he was making money when in fact he was losing money. The trader ended up blowing up a nearly 10 million pound trading account.

“Gill had sought at least 9.3 million pounds over claims that in 2001 and 2002 an MF Global account manager, who has since left the firm, told him he was making trading gains when he was losing money. Gill claimed he would have changed his strategy if correct information had been provided. Instead, he wiped out a trading account with almost 10 million pounds.”

I am, of course, all for penalizing those who intentionally deceive, so I have absolutely no problem with MF Global having to pony up some cash for this.

I can’t help but wondering, though.

How could this guy not know he was losing money? I mean seriously. If you’re trading an account worth millions shouldn’t you at least be able to track your P&L? At a minimum it is good practice to keep your own records in case there is some kind of goof up with your broker (or outright fraud as it seems in this case). A big part of me thinks this guy should be made to learn a major lesson for his own short-comings here.

Comments?

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Trading News

New NFA Rule Impacts More Than Just Forex Hedging

A couple of weeks ago I posted on the new NFA rule which effectively bans the practice of “hedging” in the retail forex market. There’s been considerable discussion on the subject of hedging and several notable brokers have given their customers the opportunity to allow them to shift their accounts to jurisdictions outside the US to permit those who wish the ability to continue hedging.

One of the parts of this new rule (2-43) that I didn’t initially focus much on is the FIFO (first-in, first-out) requirement. Some discussion about it, however, It’s made pretty clear:

Forex Dealer Members may not carry offsetting positions in a customer account but must offset them on a first-in, first-out basis. At the customer’s request, an FDM may offset same-size transactions even if there are older transactions of a different size but must offset the transaction against the oldest transaction of that size.

This FIFO requirement means that you can no longer chose which position you close if you have more than one trade open. If you are long and sell the broker will offset the earliest part of the long first. For example, if you bought a lot of EUR/USD at 1.3000, then later bought another lot at 1.3050, then sold a lot at 1.3100, the initial 1.3000 lot would be the one offset.

I do not “hedge” so the no carrying of offsetting position doesn’t phase me or most forex traders. The FIFO thing, though, is something which will impact a lot of folks. Basically it will mean that you won’t be able to close specific trades (stop or take profit) out of the sequence in which they were entered. Most forex brokers currently allow you to put a stop and/or take profit right on a specific position. This will not be permissible anymore under the new rule because they will be required to close your first trade before closing any others.

Now, if all you do is trade a single trade at a time, this my not be that big a deal. It depends on how you work. What it seems likely to require, however, is having to put on separate stop and take profit orders. This may seem fine, but consider a situation where you’re away from your computer and your stop gets hit, then later the take profit order is hit. You’d end up with a position you’d never intended. This is solved by setting up a One-Cancels-Other (OCO) order, but not all brokers do that at this point. Hopefully they will be pressured into changing that now.

I’ve spoken with someone at FXCM on this issue. It’s one they (and I’m sure all others) are working hard to figure out.

I’ve said from the start that this new NFA rule is just about getting retail forex in line with other markets like stocks and futures – standardizing the accounting for trades and positions. This FIFO thing is just doing that. I’ll admit it creates a bit of a shift in the mechanics of putting orders in and such, but if you’ve ever traded stocks, futures, or any other markets then it won’t be unfamiliar.

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Trading News

No Evidence of Stop Hunting by Retail Forex Brokers

The subject of stop hunting continues to come up quite frequently, especially where forex trading is concerned. In response to a thread on the subject, Skalpist left the following comments on a BabyPips forum entry (the main question of the thread was whether Oanda runs customer stops). I certainly haven’t done the kind of testing mentioned here, but I agree with the general conclusion.


I’ve tested this theory on A LOT of brokers. I have yet to find a broker that really stop hunts. One way to test this for yourself is to run multiple copies of MetaTrader each with a different broker.

At 4Squared, at one time we were doing this for 18 different brokers at once and tested across all of them for 6 months. In all that time, there was not a single SHRED of evidence that any of the brokers did anything remotely like what they are repeatedly being accused of.

Oanda was one of the brokers we tested.

Thus far, in all of our testing, we have found a 100% correlation between traders simply making poor trading decisions and their claims of stop hunting.

In short, Oanda doesn’t stop hunt, neither does IBFX, neither does FxOpen, or FXCM, or …

In the case of Oanda, they have something north of 1 billion in deposits and several hundred million in active trades. Do you really think a company that is making that much money servicing trades is going to screw it up in such an easily verifiable method of stealing? Give me a break.

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Trading News Trading Tips

Forex “Hedging” Continued

In yesterday’s No More “Hedging” for Forex Traders post I pointed out a new rule from the NFA going into effect on May 15th which effectively eliminates “hedging” as it has come to be known in the forex market. That’s holding simultaneous long and short positions. In every other financial market doing that is an offset, meaning the trader has no position. The NFA ruling thus brings forex in line with markets like futures. (It should be noted that having opposing positions in different accounts is restricted, so technically folks can still “hedge” if they so choose.)

Predictably, given the feelings that have generally been demonstrated on the subject over the years, there was a pretty intense response. Some of them are on my side – the one which says that hedging does not provide a net benefit to the trader, but does make the brokers more money. Some of them were of the opposing view. One person left a lengthy comment in defense of “hedging” which I wanted to take the time to address separately since it very much outlines the view of many of those who employ these strategies hold.

Here it is. My comments are below.

I am a Forex Trader/Investor. I have 3 Live Accounts with 3 different Forex Brokers. I trade Full Time for a Living. Forex Trading is Our Only Income. I was extremely shocked to hear all the buzz in the Forex Community that you guys were trying to Ban Hedging. Then, I saw in one of your e-mails about it and almost passed out. I started to wonder, whose side are you guys on?

If you Ban Hedging, you would essentially be giving the Forex Brokers/Market Makers a License to Steal from Us the Consumer. Here are the reasons you should Never Ever, Ever Ban Hedging, if, your purpose is to Protect the Consumer/Trader/Investor.

The Forex Market is extremely volatile. When Trading, you Always have to Protect Your Account Balance either, with a Stop Loss (which the Brokers and the Market Love) or a Hedge Position (which the Brokers and the Market Hate) if the market turns against you. If you Do Not use one of the 2 above mentioned Protections, you could Lose, and probably will Lose, your Entire Account Balance, and be out of business.

When you use a Stop Loss the Brokers know exactly where all the Stop Loss Orders are, and often, the price will magically reverse and go up through price areas where people would put, and do put stop losses. (This is called a stop run. This is done intentionally by the Brokers/Market makers) I have seen this happen daily for almost 4 years now.

For 3 years I have taken a beating in the Forex Market due to being Stopped Out and taking loses. My loses STOPPED when I learned about Hedging!!! Up until recently, the Brokers had a field day with my Stop Losses. Now that I know about Hedging, all 3 of my Trading Accounts have grown instead of shrunk.

Just yesterday I had a situation where I sold the EUR/JPY and it mysteriously started going the wrong way. I double checked all my reasoning for selling the pair and couldn’t figure out why it was going up. (This happens in the Forex, sometimes Mysterious, and Magical Moves Happen with No Explanation)

After I was down over $2,000.00 per account (over $6,000.00 total) I bought the pair with the same amount of lots, Stopping My Loss without having to Close My Losing Position and Taking a Real Loss of over $6,000.00. (Or, in other words, I put on a Hedge) (If there was no Hedging, I would have had to use a Stop Loss and incur the Loss of over $6,000.00)

After putting on my Hedge, I went to sleep, this was at about 4 am est. The next day I looked at the charts around 1 pm or so. I saw that the EUR/JPY had moved up substantially while I slept. (Boy was I glad I put the Hedge on when I did!!) Anyway, the Pair was showing clear signs that its move up was over, and that it was going to go down now. I closed out my Hedge and banked over $7,500.00 per Account or ($22,500.00 Total) Now I only had to wait for the price to move down to where my negative on my initial trade was at minus -$7,500.00 or less and close it out, thus giving me a break even or a profit depending a what price I was able to close out the losing end at.

I ended up closing out my losses at minus -$6,000.00 thus making $1,500.00 per Account or ($4,500.00 Total) because I was able to Hedge, If not, I would have lost over $2,000.00 per Account or (over $6,000.00 total)

This is not an isolated incident. Because of being able to Hedge, I am now a profitable Forex Trader able to beat the Brokers/Market Makers at their own game.

PLEASE DO NOT TAKE AWAY HEDGING AND GIVE BROKERS A LICENCE TO STEAL!!!!!

HEDGING PROTECTS THE CONSUMER FROM THE BROKER AND THE MARKET ITSELF!!!!!!!”

Brokers Hate Hedging
First, let me address the idea that brokers love stops and hate “hedges”. This is complete and utter crap. Think about it. “Hedging” means more trades. Brokers make their money on the spread and/or on commissions. The more trades that get made, the more spread or commission they make. This applies to ALL forex brokers – the dealers and the ECNs alike.

The brokers running stops argument is mainly that the brokers are trading against you. First of all, ECN brokers do not take any positions. They are like stock or futures brokers with no influence at all on prices. So if you have any concern at all about your broker being on the other side of your trade, switch to an ECN.

As for the dealing brokers, realize that the vast majority of positions held by customers are offset by those held by other customers and/or hedged in the market, so the brokers are generally not in an exposed position to price movements. I’m not saying they are never net long or short, but my point is that they stand to make plenty of money in a zero-risk position by simply buying at the bid and selling at the offer like any market maker in any market.

Also keep in mind that stop orders are both entry and exit orders and they can be used to both exit losing trades and to lock in profits. In other words, just because there are stops it doesn’t mean that if they are triggered the broker makes money.

I will not be so foolish as to suggest that market makers – be they brokers, bank dealing desks, hedge funds, or whoever – don’t look to run stops. It happens, just like it happens in exchanged traded securities, and has done for probably as long as there’s been the ability to leave an order in the market. The regulators do their best to prevent fraud, but it doesn’t take fraud to figure out where a lot of orders may be sitting and take advantage of it when the opportunity arises.

To specifically address this person’s gripe about their stops getting hit all the time, my feeling is that they are probably putting them much too close to their entry points. Regular readers know I’ve addressed that particular subject many times.

Looking at the Scenario
Now let me address the scenario brought up above. I’m going to express it in terms of a trading full lots of EUR/USD to put it in terms that will be perhaps a bit easier to understand because of the easy pip-to-dollar conversions – a 1 pip move in EUR/USD for a full lot position being worth $10. So let me lay it out.

1) Trader goes short 5 lots (I don’t know if that’s right, but follow me with the numbers).

2) Market rallies 40 pips, putting the account $2000 in the negative ($10 x 5 lots x -40 pips)

3) Trader “hedges” by going long 5 lots.

4) Market rallies 150 pips. Long position is up $7500 ($10 x 5 lots x 150 pips), but short is down $9500 ($10 x 5 lots x -190 pips), so the trader is still -$2000 net.

5) Trader exits long

6) Market drops 70 pips. Short position is now down $6000 ($10 x 5 lots x -120 pips).

7) Trader exits short. Final profit is $1500.

This all might sound well and good, but now I’ll show you why this trader is no better off than someone who exited the short position at 40 pips down, then sold again at 190 pips up. I’ll use prices and do a side-by-side comparison.

Hedging Stop and Re-enter
1) Short 5 contracts at 1.3000    Short 5 contracts at 1.3000
(selling in both cases at the bid)

2) Long 5 contracts at 1.3040     Exit short at 1.3040
(buying both at the offer)

Net P/L -$2000                                Net P/L -$2000

3) Exit Long at 1.3190                     Short 5 contracts at 1.3190
(both executed at the bid)

Net P/L -$2000                               Net P/L -$2000

4) Exit Short at 1.3120                    Exit Short at 1.3120

Net P/L +$1500                              Net P/L +$1500

As you can see, the two approaches achieve exactly the same result. The putting on of the long position when the short is 40 pips under water locks in a $2000 pip loss just as surely as if the trader exited the short then.

Wait, I need to correct myself there. The results aren’t exactly the same.

It sounds like the hedge approach actually involves an overnight carry (per the outlined scenario), while the strategy which stops the trader out does not. That means the hedger is paying the net interest differential, so actually he is going to end up making slightly less – in this scenario.

But Really, It’s Much Worse
Generally speaking, one goes long because they expect the market to rise. The trader in the scenario above clearly thought at the point where the market was 40 pips against his position that the odds favored it continuing in that direction, otherwise he would just stay net short. That being the case, a long position makes sense from there. If the trader had taken the -$2000 hit on the initial short, he could have made $7500 going net long. Instead of being still -$2000 in net when taking off the long hedge, he would have been +$5500.

And of course there’s the lingering question of what would have happened had the market kept moving higher after the trader took off the long position? The losses would have just kept piling up is the answer, of course. Or what would have happened if the market actually did turn around and go in favor of the initial short trade after the long hedge was put on? The trader would have forsaken that opportunity by being net neutral.

Hedging Doesn’t Solve the Problem
My experience in talking with traders about hedging as a stop is that it’s being done by traders who simply use it as a way to avoid taking a loss and being wrong, with all the psychological ramifications therein. It doesn’t promote the development of good trading. In fact it hampers it by blurring what’s really going on so the trader doesn’t get a realistic view of what’s happening with his trading.

From the way the note was written, it sounds like the trader looks at the whole set of positions as a winning trade when in reality it’s basically a couple of different trades. It doesn’t force the trader to look at that initial short as the loss that it was, which viewed properly would then encourage the trader to contemplate why it was a losing trade.

Further more, the hedging action doesn’t provide the clean slate which being completely out of the market does. Part of what exiting a position does for you is allow you to take an fresh look without the bias having a position creates. In the scenario above it could have allowed the trader to see the opportunity for a long trade which would have made very nice gains.

As always, thoughts and opinions are welcome and encouraged.

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Trading News

No More “Hedging” for Forex Traders

The National Futures Association (NFA) has a new ruling which goes into effect on May 15, 2009. It addresses the practice of “hedging” in forex trading, which is the act of holding both long and short positions in the same currency pair at the same time. Here is what the NFA had decided:

Offsetting Transactions

New Compliance Rule 2-43(b) requires an FDM to offset positions in a customer account on a first-in, first-out basis, thereby prohibiting a trading practice commonly referred to as “hedging.” A customer may, however, direct the FDM to offset same-size transactions even if there are older transactions of a different size. Rule 2-43(b) is effective for any positions established after May 15, 2009. Offsetting positions that were established prior to the effective date do not have to be liquidated, but once either position is closed out after May 15, it may not be reestablished as a hedge.

From the NFA’s April 13 press release.

Basically, what this means if you attempt to go long and short the same pair at the same time you will be end up with no position – your broker will offset them against each other and you’ll have no trade left open. For those who trade with brokers like Oanda, this is no change at all as that’s always been the case. Traders with other brokers who have allowed “hedging” will see that change shortly.

If you’re not aware, NFA is the industry organization to which forex brokers in the U.S. belong now that the CFTC has been given regulatory authority over forex trading (FDM stands for Forex Dealer Merchant). It does things like setting the minimum capital requirements for the brokers. The bottom line is that between the CFTC and NFA forex brokers are no longer unregulated in the U.S.

I have long made my feelings about this so-called “hedging” known (see How do you hedge in the forex market?). It probably goes without saying that I am quite happy to see this rule put in place because I have always considered the allowing of this “hedging” by brokers to be nothing more than a way to bilk their customers out of extra pips with zero benefit to the traders.

Addendum
A forex (and futures) broker contact of mine says he made the following comment about the new rule:

Regarding hedging it is my understanding now that day traders can still hedge but cannot hold overnight yet if one opens a new position after the beginning of a new session that just happens to hedge an open position from the previous session…

Even so I don’t really care, what I do care about is the NFA wanting to convert spot to futures with their FIFO rule for getting out of orders – I have a huge problem with that.

I don’t know if the overnight thing is true or not.