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Risk comes in many ways. Most people only stop to think about a stop loss for a trade they are in while the market is open and actively trading.
But consider for a moment some events that can dramatically effect risk:
Terrorist attack
Huge earthquake in major city
Flash crash
Nuclear event
Regime change
Just to name a few. Any of these can happen at any moment. They could happen in the middle of a cash session. They can cause the markets to be halted. They can cause huge gap downs, blowing well past your stop.
I think one of the most important things you can possibly do to succeed as a trader is to manage and accept risk. In order to do that, you have to know what the risk. Or better still, you need to be prepared for the unknown or unexpected.
All of this usually involves being more conservative than aggressive. In other words, you have to curtail your greed in order to be safe. You cannot be both greedy and safe(conservative) at the same time, usually.
Only you can decide what your risk level is, and how much risk you are willing to take in proportion to achieving alpha. But I encourage you to try and examine risk in such a way that you are prepared for the unknown.
Lesser events can still wreak havoc if you are not prepared, such as the unexpected bankruptcy of a big firm. It can send the markets spiraling down in an instant. Some people trade without stops, imagine how bad this could hit them. And consider the larger portfolio position, if you have 20 trades on, all risking 2%, you can be down 40% of your account in minutes. I hope those hedges work...
Some people call these Black Swan events. In lesser degrees, they may simply be referred to as fat tails. But the point is, the market experiences these events far more often than most people realize or are prepared for.
Does anyone have advice on how to prepare for the unexpected, with regards to your trading portfolio?
Great question. A few items that help tremendously:
1) Have your broker's phone number handy. Sometimes the old school way is the best.
2) A second broker (preferably with a different clearing firm) where you can offset your trades. This will help in cases where counterparty risk is the concern. Alternatively you could use options to offset your trades.
3) Minimizing time in the market. Obviously this is strategy dependent. But it stands to reason that if you aren't in the market when disaster hits then you've avoided risk.
4) Accept that "bad things" can happen. If the market has gapped through your stop don't stand there like a deer in the headlights. Just get out when you can. The market gapped 100 points against you. Ok. Take the loss and move on. You won't have the emotional capacity to trade well for awhile after something like this happens. Not until you accept it fully. But the truth is it isn't that hard for you to make back the 100 points and more once your mind is back in the right place.
If your trading capital is a small fraction of your net worth (< 5%) and you keep in trading account only funds you can afford to lose then you shouldn't worry about these unxpected events. If all you have is 10K and you invest them all to maximize return then you should worry. Good topic!
I have fairly small targets - 4 ticks is my first target. My stop is about the same.
The smaller your targets, the larger the size needs to be in terms of contracts. That size does indeed carry with it a higher risk of ruin in the case of a major disaster.
That leads you to looking at smaller trades/larger targets.
On the flip side, I think that even in a major disaster, it will take time for the market to assimilate that information. Even if California slipped into the ocean, I think the market would be offside 4 ticks before the real panic set in. I think the reaction would take time to build up before you saw a mass sell off.
So, in theory smaller trades, larger targets are the right solution. In practise, I won't change anything because I think that my exits are close enough that whilst I might slip, it will be by 10's and not 100's of ticks.
What about a terrorist attack on the wall street computers. What about just a technical glitch.
A few weeks ago, NYMEX halted CL due to technical problems (if memory serves, an out of control algo). When it re-opened, there was a large gap - enough to easily be 10x your 4 tick stop.
A few weeks ago, Russia's entire market was halted.
Again, this stuff happens all the time and I think is likely to happen with more frequency in the future, not less.
Maybe a 10x greater stop than you expected won't make much difference in the grand scheme of things, but the point is I think you should try to at least be prepared for such events. Know they will come, eventually.
If you watch the CNBC feed during 911 you saw the market took awhile before it plummeted for the day. Not sure why , the NYSE was right there,sell off should have started quickly after the second plane hit.
Hard to tell what the emotions of people would be,lots of factors.
Good to be scalper! Risk is minimized against the Blackswan eventto a certain level though stops will be jumped if all hell breaks lose. Doubt anything can be totally controlled.
Well - I'm not sure I'd agree that these things happen all the time because I've never witnessed something like this in my time trading and I trade the US AM 90% of days.
Still - how do you prepare, other than being well capitalized?
A bucket to throw up in by the side of your trading desk? Wire your chair up to the mains?
I guess you could open multiple smaller accounts so that you only wipe out one of them, worst case.
Smaller size/bigger targets is a potential solution but that is a huge change for me and I'm not sure it's warranted.
If I remember correctly, the attack occurred pre-market.
I was at my trading desk at the time and the futures market reacted immediately.
That was why I knew something had happened and started checking the news feeds.
Unless you were swing trading, the move pre-market was violent enough to take you out of the trade and give you a substantial black eye in the process.
As I remember the volatility was intense.
Rejoice in the Thunderstorms of Life . . .
Knowing it's not about Clouds or Wind. . .
But Learning to Dance in the Rain ! ! !
I'm a recent (but sceptical) convert to Nasim Nicholas Taleb, options trader, thinker and author of The Black Swan along with other titles.
Working from the assumption that there will be a major shock at any time, rather than assuming such an event is 'unlikely today' has forced me to rethink parts of my trading and how I understand risk.
Redundancy is a key concept, i.e. do not over optimise your risk allocation. Kelly formula may be great on paper to squeeze every penny of reward from the risk we are taking on. But it is working within the confines of the likely - not the realm where anything can happen. A good example in The Black Swan is the fact that US banks lost ALL the money they had EVER made EVER in just one quarter in the 1980's. All the wealth created in the preceeding 200 odd years gone. No doubt they were using Optimal f / Kelly Formulaes or some other maximising approach.
And whilst the government was on hand to bail them out, I don't expect it will do the same for an independent trader.
