What are ELS Orders?
This article also explains the basics of the risk management under the FIFO rule. If you are already familiar with this topic, just skip to ELS Order section.
NFA Rule 2-43(b) (aka FIFO Rule) and Stop/Limit Orders
As you probably know, NFA introduced rule 2-43(b) in 2009. All U.S. based accounts are subject to this rule. The two most important points of this rule are:
1) The rule forbids hedging.
2) The rule forbids “selective position management”.
In other words:
1) You cannot keep both short and long positions in one instrument at the same time.
2) You cannot close any position (of your choice) in the instrument. The positions in one instrument must be closed exactly in the same order as they were opened. So, you must always close the oldest position in the instrument first.
In fact, the second point forbids you to use stop and limit orders. These orders are attached to a position and when a market condition is met, these orders must close the position they are attached to, even if this position is not the oldest one. So, these orders can violate rule 2-43(b) and, therefore, are forbidden for all U.S. accounts.
Risk Management under FIFO Rule
Despite the fact that Stop and Limit orders are forbidden, you still can use conditional orders to protect your positions. If you look at point 1 of the Rule – the hedging is forbidden too, so the opposite entry orders will close the existing opposite positions if such positions exist.
So, let’s see how we can protect a position under the FIFO rule.
Let’s say we opened 10K EUR/USD long position at 1.3. Then we create a 10K entry sell order at 1.28 (order 1) and a 10K entry sell order at 1.32 (order 2) and join these orders into OCO (One-Cancels-Others).
In case the price touches 1.28, order 1 gets filled. It sells 10K of EUR/USD. Since hedging is disabled, no new position is created, the existing long position is closed instead. Since order 1 and order 2 are joined as OCO, order 2 is cancelled.
So, when we have only one position per instrument, the pair of opposite entry orders joined into OCO works almost like stop and limit.
However, this approach has two serious disadvantages:
1) When the position is created using an Entry order, you cannot create Entry Stop and Limit until the Entry Order is executed. So, there is a chance that the position will be unprotected on the market during the time period when the entry order is already executed but Entry Stop and Limit orders aren’t created.
2) If the position is closed manually, the Entry Stop and Limit orders remain active and will create a new position when the market condition is met.
So, using regular entry orders for protecting positions requires monitoring the market all the time to create and/or delete opposite entry orders.