Of all the different financial markets that offer individual traders and investors the opportunity for speculation, the foreign exchange currency market (Forex) long-held the reputation of being the most deadly to the unwary.
One big contributing factor to this perception would have been that retail Forex trading was by far the newest thing out there.
At one time the foreign exchange market existed solely to permit governments, multinational banks and corporations doing business in multiple countries to change one currency into another for their various business and trade related purposes.
True, they all attempted to do this in the most advantageous fashion, swapping currencies when the exchange rate was most favorable, but it was not until the widespread adoption of electronic trading technology made possible by powerful personal computers and the build-out of high-speed Internet networks that Forex trading moved into a realm similar to that of stock and commodity futures trading.
Brokerage firms pounced quickly to supply the demand of traders wanting to participate in currency trading.
Being for the most part not nearly so regulated as other trading instruments, all manner of enticements were devised to attract clients, along with outlandish claims of fantastic fortunes to be made requiring ridiculously small investments and no hard work of participants that could be achieved in almost no time.
It was somewhat reminiscent of the California Gold Rush of 1849, where normally sane/practical individuals gave up everything that had required a lifetime to accumulate, only to discover that, for most, there was only death, starvation and hardship, not gold, “In Them Thar Hills.”
Naive Forex traders soon learned a harsh reality: attempting to predict the future value of currency exchange rates was extremely difficult and risky.
Many would be Forex millionaires quickly discovered that Forex brokers held all the cards and that they had little or no legal recourse should they either perceive, or had in reality, been the victims of deceit at the hands of an unethical Forex broker.
The wailing and gnashing of teeth among fleeced traders was sufficient for regulatory bodies to get into the act.
Many examples from world history would seem to prove that when governments attempt to regulate something, for whatever reason, that something becomes a) scarce, and b) expensive, which would seem to reveal our stance regarding regulatory intervention in free markets where the forces of supply and demand seem to provide all the control necessary, but there you have it.
Regardless of how we feel about the subject, National Futures Association (NFA) rules went into effect on October 18, 2010 that have profoundly impacted Forex traders in the United States.
Most of these regulations affect brokers more than any other market participants, mainly with regard to capitalization requirements and risk disclosure, but there are a couple that affect traders.
We will look at two of these more closely.
Leverage Limitations
One thing that has been greatly changed is the amount of leverage a broker can make available to their clients.
Prior to the effective date of the regulations, brokers could offer any level of leverage they thought would induce the most clients to select their brokerage.
The new regulations cap leverage at 50:1
It was thought by many Forex market analysts that this leverage reduction would drive many traders to seek trading accounts with brokers located outside the U.S. who were exempt from the new leverage limit.
It may be too soon to determine this, but common sense alone would seem to indicate that if a trader cannot be profitable at 50:1 leverage, higher leverage offers no benefit.
We will not provide a thorough explanation of leverage here.
Suffice it for now to know that the higher the level of leverage, the higher the number of currency units available for sale or purchase by a trader. The more units controlled, the larger the impact of currency price changes on trading equity. Leverage can work for or against you.
Be absolutely, 100% sure you have a thorough and intimate knowledge of how leverage works.
Given that all Forex brokers will permit practice trading and that most Forex trading platforms feature the ability to practice using different levels of leverage, there is no excuse for failing to understand the concept of leverage. There are also a multitude of free Forex education courses that will tell you everything you ever needed or wanted to know on the subject.
First in/first out (FIFO) accounting
No, FIFO is not the name of a dog belonging to a person with a speech impediment.
Prior to FIFO rules, it was possible for a trader to buy a certain number of currency pair units while simultaneously selling the identical number of units of the same currency pair.
If you find yourself tempted to ask, “What’s the purpose of doing that, anyway?”, you need to acquaint yourself with the concept of arbitrage.
Traders engaging in this practice would simultaneously buy and sell huge quantities of currency units of the same currency pair, hoping to make an instantaneous profit on the difference between the buying and selling price.
Under the new regulations, however, a currency transaction to buy, as an example, X units of a currency pair must be exited before a transaction to sell X units of that same pair can be initiated.
The FIFO accounting method is familiar terrain to commodity futures traders, but many Forex traders who were accustomed to the old way of doing things were decidedly disgruntled at having lost what was a reliable source of profits.
What do the new rules really mean?
Very shortly after the first group of cavemen got together and created the first Cave Owners’ Association to discourage a less fastidious caveman neighbor from leaving rotting dinosaur carcasses strewn about outside his cave, which attracted undesirable scavengers who seldom made much of a distinction between dinosaur carcasses or cavemen as a food source, along with negatively impacting cave resale values, that caveman decided he was living not in a cave, but in a cavern, creating history’s first loophole.
Forex traders are every bit as creative as that caveman.
While we do not advocate doing anything illegal, immoral or unethical, we do feel the necessity of supplying some guidelines regarding how best to adapt to the current Forex landscape.
Regarding the 50:1 leverage, we don’t necessarily oppose it all that much. In fact, new traders would be prudent to trade at a lower leverage level to begin with and thus avoid the temptation to get over extended and dig a hole from which there is no escaping.
If you’re an older trader and must absolutely have higher leverage, you need a broker that does not have the requirement of complying with the NFA regulations. This would be any broker outside the United States that does not have a U.S. presence.
In all probability, this loophole will eventually disappear.
FIFO is circumvented simply by changing the quantity of currency units bought or sold. This enables a trader, as an example, to buy X number of currency units, then buy 2X units, then close the second 2X unit transaction at any time without being required to first close the X unit transaction.
Be aware, however, that if in the above example, a trader attempted to sell any portion of the previously purchased units, that portion would come from the first transaction.
Of course, there is nothing to prevent a trader from having an account with two or more brokers and some brokers allow traders to have one or more sub accounts within a main account, so FIFO regulations are rendered essentially moot, more of a minor inconvenience than anything else.
A trader can also simply trade different currency pairs, going long in one pair while simultaneously going short in a correlated pair were price movement in one closely mimics that of the other.
While we’re on record as being opposed to excessive regulatory intrusion into the free market, we must admit that leverage limits and FIFO regulations may benefit the Forex market to a certain degree.
The more new traders that can be given the opportunity to survive long enough to learn the ropes of the Forex market, the better are the chances for sustained price trends. These trends mean profits for some and losses for others, but without this potential there is no reason for a Forex market in the first place.