Why Forex Traders Can't Hedge Anymore

05/01/2009 12:01 am EST

Focus: FOREX

John Jagerson

Co-Founder and Contributor, LearningMarkets.com

The NFA (National Futures Association) proposed a rule change to the CFTC (Commodity Futures Trading Commission) last year that was approved and will begin applying to forex dealers in the US on May 15, 2009. There are two unrelated features in the rule change. The most controversial feature has to do with "hedging," or hedged forex positions. The second feature has more to do with the conditions that must be applied before a trader's position can be adjusted by a dealer. This article will discuss the changes and why they may not be such a bad thing.

Learn more about the new rules in today's video on hedging below.

Anti-Hedging Rule

There are some unique trader behaviors in the spot forex market. Some order types exist here and nowhere else, and some of the trading strategies and techniques that can be seen applied here are almost unknown in other capital markets.

Sometimes this is due to the nature of the most liquid and actively traded market in the world that presents unique opportunities to profit. However, often it is because the retail forex market has a larger percentage of first time active traders than any other and there are plenty of other parties waiting to take advantage of these emerging investors.

The anti-hedging rule is supposed to address a confusing trading technique used by many inexperienced traders called hedging. Traditionally, hedging is what someone who owns a spot commodity will do to fix their price rather than suffering from unpredictable market movements in the future. For example, a corn producer may sell corn futures against their stock so that if the price of corn goes down, they will have profits to offset their inventory losses.

The nature of a true hedge will eliminate the possibility of losses from price movement, but it will also eliminate the ability to profit from favorable price movement. This is ideal for a commodity producer, but serves no purpose for forex traders who are essentially speculators.

Despite its disadvantages, however, unscrupulous system sellers and dealers have marketed the ability to hedge your forex positions. That means that it is possible to hold long and short positions on the same currency pair at the same time even though they will clearly cancel each other out. Some traders do this as a replacement for stops or as a component of overly complicated spread and commission-generating systems or EAs.

A hedge like this only leads to losses. Rather than paying one spread to enter a trade, a hedger pays two spreads. Additionally, interest rollover will always be negative, which in the longer term could add up to significant losses if the trade is very leveraged.

Dealers told the NFA during the comment period that they did not know why anyone would want to hedge, but that because customers were asking for it, they provided the functionality. This behavior was definitely good for dealers and system or EA sellers who are paid based on the spread and are probably the parties generating the "demand" for hedging in the first place.

After May 15, a trader entering a short position on a currency pair they are already long will have their position closed or washed out. The same is true in reverse. If a trader was determined to continue hedging, they could enter the contrary position within a different margin account, but that adds another layer of complexity to an already impaired trade. While this is only a US rule right now, it is likely to be applied in the other major retail forex markets in the near term.

There are ways to legitimately "hedge" or fix risk in a forex trade while leaving the upside unlimited with options. To find out more, try our free course on forex options.

Adjusting Trader Positions

In the past, if there were "server errors" or other miscellaneous problems in the price feed from your dealer and your trade was filled at the wrong price, the dealer could alter that position according to their terms of service. It is not a surprise that most trade adjustments were in favor of the dealer.

In the future, dealers will only be able to adjust a trade price in two circumstances.

1. The trade is adjusted in favor of the customer.
2. The dealer has a STP (Straight Through Processing) dealing model that has no human intervention and they were given a bad price by their liquidity provider. This means that if your STP dealer gets a bad price from their counterparty, then the dealer can pass that adjustment through to you.

This pass through can only be done if one of the dealer's principles sign off on the adjustment and provide documentation of their bad price to you. That does make it more difficult to adjust prices and could save a lot of traders a considerable amount of frustration. 

Some traders are reacting to the rule changes with an attitude that the NFA should butt out of their business and others are more positive. Regulation is a sensitive subject, as there are many rules that make no sense, but these two changes do not seem to fall into that category. The spot forex has been the "wild west" of the trading world for too long and some increased maturity is needed.

For more details, watch the video below:

By John Jagerson, of PFXGlobal.com and LearningMarkets.com.

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