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I am a stock investor and I am very interested in trading forex futures. I have been familiar with chart patterns. I notice that in Jan 2015, USD/CHF tanked 3000 points in almost a gap down fashion. If I use daily charts and set my stop loss to 150 points for a 1% account loss, then 3000 pips would be a pretty dramatic loss. Some short term traders could even be wiped out if they size their positions to set 30 points for a 1% account loss.
What is the best way to avoid this kind of dramatic losses? Buying call/put options 1000 points away would be one approach but the cost could be high over time, and this kind of event almost never happens. But when it happens, it does wipe people out.
Can you help answer these questions from other members on NexusFi?
Once you have sat through an event like this, you realize that there is really no way to protect yourself. (I was not in that one, but have been once, at another time, and have observed them more than once.)
Your stop loss orders won't get filled because no one is interested in buying. Any other attempts to close out your position won't get filled either. You could be hedged in some way ahead of time, but that will interfere with being profitable in normal times.
There is nothing you can do.
This my not seem like the right thing to say. We always expect there is something we can do.... and there is. We can take the big loss and be glad that we only risked what we could easily afford to lose. During one of these downdrafts, normality is suspended, so you just accept it as a risk of doing business. They don't happen often, but they do happen. The only protection is to not put more money at risk than you can afford if it all goes poof.
Bob.
When one door closes, another opens.
-- Cervantes, Don Quixote
Got it. This kind of events seem to be far more often in forex where everyone is leveraged to the heel. If I buy a stock, I would be assured that its value will never go negative. Or if I short the Nasdaq index, I could be sure that it never gapped up 20% in one day. (Though I can't be sure if it would gap down 20% in one day).
So it seems like the only solution is to use low leverage?
I had written up a long response, but then I got to wondering what you mean when you say "low leverage."
The way to have lower leverage is to put up larger margin, which means have a larger account in terms of the margin backing each contract. Essentially, the risk in a true "black swan" event is that you will lose all of it. So paradoxically, lower leverage (a bigger account) will not help, and just means you will have a bigger loss.
So it comes down to, only risk money you can afford to lose.
I am not sure how you are thinking in terms of being leveraged, though, so this may not speak to you. Can you elaborate on what you mean?
Bob.
When one door closes, another opens.
-- Cervantes, Don Quixote
You guys are worrying about an excessive tail risk. You have to consider the odds of such an event happening while you have a trade open is non-zero, but very close to zero. Even if a black swan event happens, there's no guarantee you are trading that day or are in a trade.
To hedge your risk, you could place an opposing option for every single trade.
Short futures, buy calls at higher price than futures. This limits your upside risk and reward.
Long futures, buy put at lower price than futures. This limits your downside risk and reward.
But is it worth it? Depends on your strategy and risk tolerance.
If I have 200k in the account and buy one micro dow contract, I will never have a wipe out because the notional value of this contract is smaller than the account value. This will cause the return to be far less, but I still focus most on stocks anyway, so that's ok.
The problem with "risking the money you can afford to lose" is that during the CHF 3000 point drop down, some traders got their accounts deeply negative, so they not only got wiped out, but also faces collections, which will ruin their lives.
Trading small amount of contract (relative to the account holders capacity) and trading options contracts on buy side are usually the only ways to limit the net risk (as your maximum loss will be your premium at the time of buying), but that also means you are usually trading for small profits and possibly on small timeframes and option trading requires considerable amount of knowledge and experience.
Option selling is usually thought to be the way to limit risk in so called hedging strategies but in my personal experience, what bobwest has said can ruin all your plans if there is no one buying on other side and you end up holding the positions as it is, it also involves risk of leaving large amount of money in form of margins locked with the trade. Also most retail traders and even professionals never reach a stage where this is their primary trading method.
Just my 2c, please note that I only trade Indian markets and my knowledge is limited.
That's what I thought you meant, and you're right. You are basically saying to not have any leverage, and in that case, you can't lose it all. But you also limit your returns, there never being something for nothing. Change the risk profile and you change the return profile (on a percentage basis) also. But that will give you safety.
Now we get to the reason why someone is trading futures in the first place. If you want to trade something that matches the overall stock market in its movements and has no leverage, you might just trade the SPY ETF, for example, and have no leverage either, assuming you buy it in a cash account.
I recall you said in another post that you were interested in trading futures in your IRA and so were concerned with safety of your retirement accounts, as you should be.
I for one would not want to put any retirement money in futures, simply because one of the main reasons to trade futures is the leverage, and I wouldn't expose my retirement funds to that type of risk (even to the normal risk of leverage, much less the risk of a catastrophic event). Which is sort of where you are going with this. If there's no leverage there's much less catastrophic risk, but also lower return. Futures may not be a good vehicle for IRA money if potential cartastrophic risk is your concern.
One other factor in this mix is that the main reason for using an IRA is the tax treatment of any gains. FYI, for non-IRA money, futures profits are taxed very differently from regular trading profits. 60% are taxed as long term capital gains (which are low) and 40% as short-term capital gains, even if the "long term" of the holding is a few hours (or minutes.) Depending on a lot of factors, this can be very favorable to the trader. It's not the same as deferring all the tax until a later date, but it's something, if you were not aware of it. Obviously, I am not a tax professional and you should consult with one, etc.
I also do basically agree with @Arch that the risk in terms of probability of happening is very small, which is actually very relevant. I would also not bother hedging with options or something, because you are then killing your ability to make gains in normal times. The question is, how large should a concern for an unlikely event of this magnitude be, and what should you do about it?
You'll have to balance these considerations in your own mind. I think that not using futures for retirement money is one viable option. But that depends on you. I don't think there is just one answer.
Last point: if you're in futures at all, it is always possible that you will have a loss that is greater than the margin you have put up. Usually the broker will just automatically close you out to protect themselves, although in some cases (some brokers, for some customers) they may first contact you for more margin. But in a true disaster scenario, they may not be able to sell you out either. So this is always an issue in the background, and one should not be in futures without having decided how to think about this unusual but non-zero risk.
Bob.
When one door closes, another opens.
-- Cervantes, Don Quixote
