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Publishedin:ForexLessons

BangMoments:HowtoProtectAgainstSNBType
Events
Fri,Jan232015,10:59EET
bySamEder|FXRenew

Youareariskmanagerfirst,andatradersecond

LastweekweexperiencedabangmomentwhentheSNBannounceditwasremovingitscurrencypeg.
Abangmomentisastatisticallyimprobableeventwhosemonumentaleffectsarefeltinasplitsecond.
Ifyourenotprepared,itistoolatetodoanythingaboutitwhenithappens.
Bangmomentsarealotmorecommonthanyoumightthink.Marketshavewhataretermedfattails
whenitcomestoprobabilitydistribution.Thatis,thingsthatstatisticallyshouldnothappenoccur
muchmoreoftenthanyouwouldexpect.
ExamplesoflongtaileventsincludetheblackMondaystockmarketcrashof1987,theeventsleading
tothefailureofLongTermCapitalManagement,theJapaneseTsunami,andlastweektherevaluation
oftheSwissFranc.
Inthissomewhattechnicalarticle,ItalkabouthowtoprepareforbangmomentsinForex,soyoucan
avoidrisksthathavethepotentialtoknockyououtofthegame,orwithabitofluckevenallowyouto
profit.

Twotypesofrisk
Whenabangmomenthappensyoufacetwotypesofrisk.
1.Marketrisk
2.Counterpartyrisk
Marketriskiswhatitsoundslike.Ifthepricegoesagainstyou,thenyouwillsuffermassivelosses
quickly,ifyouareheavilyleveraged.Itisperhapstheeasierofthetworiskstoprotectagainst.
Counterpartyriskistheriskofyourbrokergettingintofinancialtrouble,andyouthereforenotbeing
abletoaccessorwithdrawyourfunds.Intheworstcasescenario,youmaylosethemaltogether.Arecent

highprofileexampleofcounterpartyriskwasthecollapseofMFGlobal.
WiththeproliferationofpoorlyregulatedandundercapitalisedForexbrokers,thisisabigriskforForex
traders.Counterpartyriskisperhapsthemoredifficultofthetworiskstoguardagainst.

Guardingagainstmarketlongtailriskwithdeepoutofthemoney
options
Imgoingtoassumeyouusestoplossestoprotectyourselfifthemarketgoesagainstyou,sowhatIam
goingtotalkabouthereishowtoguardagainsttheriskofthepricesignificantlygappingthoughyour
stoploss,likeitdidwhentheSNBremovedthepeg.
Deepoutofthemoneyoptionsallowyoutobenefitifthepricemovesalongwayagainstyou.For
exampletheEUR/USDiscurrentlytradingataround1.1600.Ifyoubroughtacalloptionatsay1.2400
(whichwouldbedeepoutofthemoney)thatwouldgiveyouprotectionfromanymovebackabove
1.2400.Youmightpay1015pipsorsoforthisprotectionforacoupleofmonths.
Ifyouweretobuyoptionsthathaveastrikepriceclosetothemarket,theycancostquiteabit.Its
becausetheyarealongwayfromthecurrentpricethatyoucangetthemforcheap.Whetheryouarein
andout,orholdingpositionsforlongtermmoves,15orsopipsshouldnotbreakthebank.
Exactlyhowmanyputoptionstobuywilldependonyourriskmanagementobjectives.Themore
perfectlyyouhedgeyourrisk,themoreexpensiveyourhedgewillbe.Ifyouwantallyourpositionsto
behedged,thenitwillcostmoretobuytheoptions,soperhapsyouwillhedgeanypositionthatis
greaterthanthesizeofyouraccount.Itwilldependonwhatyouaretryingtoachieveinthelongrun.

Scaleintoreducecostsonlongtermtrades
Thisstrategysuitsascaleinapproachifyouarelongtermtrading.Ifyourfirstpositionissmall,then
youmaynothedgeit,butasthetrademovesinyourfavourandyouaddtoyourposition,youcanstartto
buildahedge.Asthemarkethasmovedinyourfavour,theoutofthemoneyoptionswillbecheaper
meaningthecostofyourprotectionisless.

Bewareofthecostofhedgingonshorttermtrades
Asshorttermtraderstendtotradewithgreaterleverage,thetailriskcanbegreater.(Imagineifyouhad
alargedaytradeontheUSDCHF,andthepricegappedagainstyourpositionfor2000pips).Youwill
needtodosometestingofworstcasescenarios,andconsiderhowmuchriskyouarewillingtotake
whenyoustructureyourprotection.Itsimportanttonotethatyoucanbuyandsellanoptionpretty
easily,butthecostofthespreadishigherthanoncurrencypairsthemselves.

Maximumpositionsizes
Whenyouaredevelopingyourriskmanagementplan,itsimportanttodefinehowlargeapositionyou
willhaveinanycurrencypair,orcorrelatedpairs.Youshouldalsosetthemaximumamountofleverage
youwilluseonyouraccount.

Forexample,youmightallowyourselftohavepositionstwotimesthesizeofyouraccountvalue,witha
maximumtotalleverageontheaccountoftentimesyouraccountvalue.Youcanaddthese
considerationsintohowyoubuildyouroptionpositions.

Structuringyouraccountswithyourbroker
Howyoustructureyourcapitalinyourtradingaccountsservestwopurposes.Firstly,itcanprotect
againstmarketrisk,whichIwillexplainbelow.Secondly,itcanprotectagainstcounterpartyrisk(the
riskofyourbrokergoingbust).
Thereareanumberofconsiderationstobeawareof:

MarketMakervs.ECN
Thefirstthingtounderstandaboutstructuringyouraccountsisthedifferencebetweenamarketmaker
andanECNbroker.Itisduringthebangmomentsthatagoodmarketmakercanshine.Asamarket
makerhastheabilitytocreatetheprice,theycanfillyourorderevenwhenitdoesnottradethereinthe
interbankmarket.
Andsomewilldoit.
During9/11,theJapaneseTsunamiandtherecentSNBintervention,somemarketmakersfilledstop
orderswithoutslippage.Meanwhile,thosetradingwithECNswouldhavehadtoacceptthepricesfrom
thepoolofliquidityprovidersintheECN.Generally,themarketmakerisabetterchoiceinthisscenario
(thoughnoguarantees!).

Howbrokershandlenegativebalances
Somebrokerswilltendtowipeanynegativeaccountbalancesthattheirclientsexperience(generallythe
largermarketmakerswillbebestatthis).
Whydothis?
Brokersarescaredoftheregulatoryriskfromnegativebalances.Didtheclientproperlyunderstandthe
riskthattheiraccountcouldgointonegativebalanceswhentheyopenedtheaccount?Abrokernever
wantstobeseenasshady,soitpaysintheendjusttoeatthenegativebalance.
Itisthistypeofcomplaintthatcanthreatentheirlongtermbusiness.Eveniftheregulatorswill
generallyfindinthefavourofthebroker,theywouldprefernottohavetodealwiththatrisk.So,if
possible,theywillsimplywipenegativebalances.Again,noguarantees,butitisworthconsidering.
(Ihopethisisnotseenastooscepticalaboutbrokersmotivations.Theydothisoutofapositivedesireto
helpandprotecttheirclients,too.)

Brokersarelargetradingorganizationsbutsomearenotvery
sophisticatedriskmanagers
Thethirdconsiderationtothinkaboutwithbrokersisthattheythemselvescanendupholdinglarge
positionsincurrencypairs.Thishappenseitherthroughproptrading,orduetocustomersorders.
Sometimesthisishedged,butothertimesitsnot.
Thismeansthatsomebrokers,aswehaveseen,canfindthemselvesinstrifeiftheirpositionsgosouth.
Dontputtoomuchfaithinyourbrokerbeingstaffedbygoodtradersorriskmanagers.

Keepyouraccountbalancesataminimum
Takingintoconsiderationthesethreefactors,onestrategytominimisetailriskistolimittheamountof
fundsyoukeepwithyourbroker,whoshouldbeamarketmakerwithatrackrecordoffillingordersin
adversesituations,aswellasclearingnegativebalances.
Thisdoesnotmeanyouneedtoreduceyourpositionsizewhenyoutradeitsimplymeansyoucanuse
notionalfunding.Theideabehindthisconceptisthatyoucouldhave$5000inyouraccount,butstill
tradeasthoughitwere$50,000.Youcanbepreparedtoriskyourcapital,withouthavingallofitinyour
tradingaccountatanyonetime.
Agoodapproachistokeepjustenoughmoneyinyouraccounttomaintainyourtrades,andmakesure
youdontgetstoppedout(ormargincalled!).Anyexcessfundscanbekeptinamoresecure(preferably
governmentguaranteed)financialinstitution.Youthentransferfundsintoyouraccountasyouneed
them.
Intheeventofamoveagainstyou,likewehadwiththeSNBannouncement,yourriskcouldbelimited
inthreeways.
1.Youordercouldbefilledevenifthepricedoesnottradeatyourstoploss
2.Ifyouraccountdoesgointoanegativebalance,thereisachanceitwillbewiped
3.Ifyoubrokergoesunderwhileyouareusingnotionaltrading,youwillhavelostasmallamountof
tradingcapital,ratherthanyourentireaccount.
Ifyoucombinewiththiswithadeepoutofthemoneyoptionstrategy,youcould
experienceasituationwhereanylossesonyouraccountarelimited,yetyourpotential
gainontheoptionsisunlimited.
Thisis,ofcourse,ifyouhavetheoptionsinaseparateaccountwithadifferentbroker(whichyou
should!).
Thisisthetypeoftradeyouwantonewheredownsideriskisconstrained,andupsidepotentialis
unlimited.

Beariskmanagerfirst

Overtoyou
Bangmomentscanhappenatanytime,anditisonlythepreparedthatwillbesaved(orprosper!).
Takethestepsthatyouneedtobuildariskmanagementplanthatprotectsyourtradingaccountfrom
tailriskbeforeitstoolate.
Itwilltakedisciplinetoapplyyourriskmanagementrulesconsistentlytoguardagainstrisksthatvery
rarelyoccur.But,Icanguaranteeyouonething.Whenthenextbangmomentcomes,youllbegladyou
did.
PublishedOnFri,Jan232015,11:03EET PreviousentriesofForexLessons

SamEder
FXRenewwebsite
SamEderisamacrocurrencytraderandauthoroftheDefinitiveGuideto
DevelopingaWinningForexTradingSystemandtheAdvancedForexCoursefor
SmartTraders.HeisacoownerofpremiumForexsignalproviderwww.

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