Posts Tagged ‘Risk Management’

Always have a stop, and ideally a limit

Thursday, November 26th, 2009

When trading financial derivatives such as forex, CFDs should you always use a stop?

Short answer: Yes!

Long answer: Yes you should always have a stop in place – even if you think you really don’t need one.

Note that I’m only referring to financial derivatives such as forex and CFDs where you trade on margin. If you are trading or investing in instruments where you pay the full price up front (as you will usually do with shares) then this doesn’t apply to the same extent.

Leveraged price moves

A stop is very important with derivatives because when you are trading on margin any moves in the market price is magnified (often by huge multiples –1:400 leveraged forex – are you insane!). A move in the wrong direction can easily wipe you out – along with any other unrelated positions that you currently have open. In the worst case you could even end up owing your broker money – and that is not a good place to be.

forex trading screen 4

Stops are for wimps!

If you talk to people or read the trading bulletin boards there is often a certain amount of bravado about trading without a stop. Some people seem to think that stops are for wimps or are irrelevant for the strategy they are using (“I don’t need a stop because if the market moves against me I manually close out the position in time”).

Emotional decision making

Some people may be disciplined enough to close out at a sensible price but most aren’t. When the numbers on your screen start moving against you it is all to tempting to think – “I’ll stay in a bit longer – the price might go in my favour again”. The chances are that it will just keep going against you making your loss bigger. If you have a stop then you remove your emotions from exiting at the right time.

You should decide your worst exit price when you place the trade when you are thinking more rationally. You of course always have the option to exit earlier if you realise you are wrong before you stop gets hit. Just whatever you do don’t start loosening your stop. Remember the reason you set it at that value in the first place.

My strategy doesn’t require stops

Some people (for our example we’ll call our trader ‘MrNoStop’) will argue that the strategy they are trading does not require stops. They talk about never leaving the screen when a trade is open. If something happens there are always at hand – and cool headed enough – to close that trade.

So what happens then if some huge incident occurs which has a massive impact on prices. For example an unprecedented terrorist attack. Imagine that due to the incident the internet grinds to a halt – as it did on 9/11.

Suddenly MrNoStop’s trading platform stops responding, his previously fast internet connection grinds to a slow trickle. Now MrNoStop can’t exit his trade using his computer. Never mind thinks MrNoStop – I’ll telephone my broker. I always have their number to hand.

MrNoStop calls the number. It is engaged. He keeps trying. Eventually the number rings but no one answers. What is going on? Well of course MrNoStop isn’t the only one affected by the internet outage – all the broker’s customers are affected and they are now phoning the company on mass to either find out what is going on or close their positions. If only MrNoStop had used a stop.

Even if his normal strategy didn’t need a stop he still should have used an ‘emergency contingency’ stop to prevent this kind of thing from happening. It could have saved him a lot of money.

It can be good to have a limit order in place

In the title for this post I mentioned that you should always have a limit as well. Why is this?

Well let’s go back to MrNoStop’s bad situation. It is entirely possible that the terrorist attack could have had a massive positive effect on MrNoStop’s position. The price could have spiked up and then headed back down whilst MrNoStop was unable to use the internet or get though on the phone. If he’d used a limit order as well for this trade then it is possible that he may have made it out with a profit.

Some caution suggested

Maybe I’ve convinced you that always having a stop and a limit order is a good idea.

Well I’ll give you some warnings as well. If your trading platform implements stops and limits as separate tickets from the main trade then you need to be very careful to make sure you know exactly what tickets you have open! Make sure that you don’t accidentally get into trades that you didn’t mean to. If you close your trade ticket then close any associated stops and limit orders as well. Ideally you should have a blotter listing all your open tickets permanently on screen. If you have enough monitors then using one of them for account information can be worthwhile.

If your trading platform implements the stops and limits as part of the same order (and automatically cancels the stop and limit when the trade is closed) then things are much easier. This is because you can’t end up with forgotten stops and limits that are waiting to trigger when you least expect them!

How much money could I lose trading CFDs?

Friday, July 17th, 2009

Before placing any contracts for difference (CFD) trades you should ask yourself the question of “How much money could I lose?”. If you are to trade responsibly you should always be focusing on what you could lose, not what you could win. If you are focusing on how much you could win then you are either at high risk of losing a lot of money, or you could even be a gambler rather than a trader.

There are several different ways of looking at how much money you could lose.

Lose as much as you put in

A small number of CFD providers will cap your losses at the amount of money you have in your account (or offer a lower risk account which guarantees this). If you have an account with a company who does this then your worst case loss is obviously whatever money you put into your account.

Even if your CFD provider doesn’t cap your losses then you may be able to fix your maximum risk by using a guaranteed stop. Unfortunately there is usually an extra charge for these, often in the form of a larger spread.

Lose your entire position size – going long

Most CFD account providers have agreements that say you must cover all your loses – which can be larger than your account balance. They will usually close out your trade before your account balance hits ‘0’ but in a very fast moving market you might be closed out with a negative balance.

If you are betting long then your theoretical maximum loss will be your total position size. If you bought £10,000 of Vodaphone shares using CFDs then you may have only needed to put down a £100 deposit (if we assume a 1% deposit requirement) but your loses could far exceed that £100. Your maximum loss would occur in a situation where the share price went down to 0. If you’d used CFDs to buy £10,000 of shares and the price suddenly plummeted to 0 then you could owe £10,000 if your trade wasn’t automatically closed out.

Could this happen in real life? Certainly share prices can go down to 0 – recent cases of large companies collapsing include Enron and Lehman Brothers.

If you were going long on indicies, such as the FTSE 100 then your theoretical loss would be the loss that would be incurred if the index went down to 0. As I write this the FTSE100 is at 4365. If I bought at £1 a point then my theoretical risk is £4365.

Unlike shares which can go down to 0 a share index is very unlikely to. It the FTSE 100 ever dropped to 0 then that would probably mean that the UK had been nuked to oblivion. In which case you may well be dead and your CFD broker wouldn’t exist either! Very unlikely but it is always worth bearing in mind just how much money you are playing with.

Could the value collapse so fast that you would end up owing far more than your account balance? You can end up owing your CFD provider more than you balance if you have a very large and highly leveraged position, and things move fast. In this case it may simply not be possible to liquidate your position fast enough to prevent your loses.

Losing a fortune – going short

The amount you can lose is often defined in terms of prices going down. Of course with CFDs we can bet on prices going up and down. How much could you lose by going short?

In theory you could lose an infinite amount of money!

I’m not saying it is likely – just theoretically possible. Lets imagine that you think UselessPowerPLC is going down. It is at 5p per share and you think it will fall further. You sell £10,000 worth – this is 200,000 shares. It is a small share and you need a 10% deposit. In other words you have to put down a £1000 deposit. They make an unexpected announcement – they have perfected fusion power, using patented technology, and can now produce almost unlimited amounts of power extremely cheaply. The company will make billions! The share price rockets to £20 and moves so fast that your CFD provider can’t close your position out in time. Suddenly you owe your CFD provider £3,990,000 (200,000 * (£20 – £0.05)). Yes – nearly £4 million. Crikey. Stretching the bounds of believability perhaps, but it makes a point about how risky the CFD game could be. Especially if you make stupid bets!

Is any of this really likely to affect me?

How fast could prices move? Very fast. Look at the stock market crash page on Wikipedia. How would your account have coped during one of those days?

My doom-munging scenarios wouldn’t normally happen of course. You CFD provider knows that trying to claw back debts from customers is much harder, and more expensive than simply deducting the money from their account. This is why they have automated systems in place to try to automatically close your positions before you get into this predicament. If you do find yourself in this predicament then you should look at the way you are trading – it probably means you did something very stupid, i.e. holding positions that were far too large and highly leveraged.

Although the unlikely is by definition ‘unlikely’, is always worth thinking beyond your usual risk scenarios. Don’t forget that a factor of the current credit crunch was that banks rejected the sudden default of hundreds of thousands of mortgages as being such an unlikely thing to happen that it wasn’t worth taking seriously. Ooops! Fortunately the banks had the government to bail them out. If you mess up then the banks certainly won’t be bailing you out.

The simple moral – consider the usual risks, and then consider beyond the usual risks. If you are still happy then you can play the CFD game. If you aren’t happy then maybe you should put you money in the bank.

Avoid getting screwed by your CFD / Forex trading broker

Thursday, June 18th, 2009

If you read trading forums such as trade2win and babybips then every so often you’ll come across someone who is asking for advice as it appears that they have been well and truly ripped off by their broker. I’m sure most brokers are honest but here are a few things you can to avoid the risk of bad things happening to you.

When you start generating a profit make sure they’ll let you withdraw the money

There are stories of people who have spent a lot of time building up their trading account, only to find that they have a lot of trouble getting the money back out. In the worst cases there are reports of people who can’t get their broker to give them any of their own money.

You could get into problems if:

  1. You have closed the bank account which was originally registered with them. For fraud prevention purposes they may make you jump through hoops to get a new account registered. Of course you’ll never have any problems paying money to your broker from whatever means you want. Similarly you could run into problems if they pay the money to your credit / debit card and it has expired.
  2. They tell you they have problems verifying your identity and require more details. This could severely delay your cash withdrawal as you’ll have to post/fax off whatever documents they request.
  3. They simply ignore your request. Sometimes it seems that requests to withdrawer your own money isn’t a very high priority for them.
  4. Your broker tells you that you have broken a rule in their terms and conditions. Have you read yours? They could easily say that because you haven’t obeyed whatever obscure rule they are suspending / terminating your account and won’t give you any of your money back.

The lesson to learn here is that as soon as you have made some money test their account withdrawal procedure. Take some of the money out and have it paid back to you. And then regularly transfer money out – if you are good at trading you should in effect be ‘paying yourself a salary from your trading account’.

Not only does making regular money withdrawals prevent you from running into this particular problem it also prevents you from accidentally losing your account with a highly risky trade gone bad or from some other trading mistake.

Don’t let your account get too big

This is related to the above advice. If your account gets too big then you will start getting noticed by your broker. This can cause all kinds of problems for you as they may start referring your trades to the dealer or be less willing to pay your money back to you. Best to stay ‘under the radar’ and withdraw money regularly. Of course this is only a problem with you are able to win regularly enough to get a big account balance 🙂

Keeping your account small also has a few more advantages.

  1. If a trade goes badly wrong (e.g. you bet the wrong way, the price massively moved and you didn’t have a stop!) your broker is likely to automatically close the trade for you when the balance gets within their minimum liquidity limit. If you had a huge pile of cash in there then your cash would just get eaten up until it is all gone.
  2. Keeping a small account means you are less likely to be tempted to get into overly risky trades.

Don’t build up huge positions

If you keep on putting more and more money into a winning position then you may run into problems when you try to close it. I’ve heard of people being ‘referred to dealer’ at the critical moment, which of course could lose them a whole load of profit as you either have to wait for the dealer to accept the trade or call them up. In the wrong conditions this could even turn a winning trade into a losing one.

In one horror story that I read the guy claimed to have built up a position of £1000 per point! That’s an insane thing to do with a retail broker and is bound to get you noticed when most other people are betting in the single or double digit range per point. If you are able to play around with that kind of money then you should probably be getting a professional trading account.

As with the previous tip you are best off staying away from their watch lists by keeping your positions small.

Conclusions

Regularly take profits out of your account. It is much safer in your personal bank account than in your trading broker’s account. It is much harder for your high street bank to refuse to give you back your own money than it is for a broker. You certainly don’t want to be with any broker who makes a fuss / takes too long / or just generally makes it difficult for you to withdraw your trading profits.

Don’t make yourself stand out from the crowd! It is best to be one of the masses rather than getting ‘special attention’ from your broker. Withdraw your money regularly to keep your account at a reasonable level and keep the size of your trades within the standard range that the broker would expect.