“You are a risk manager first, and a trader second”

Two types of risk

Guarding against market long-tail risk with deep out of the money options

Scale-in to reduce costs on long-term trades

Beware of the cost of hedging on short-term trades

Maximum position sizes

Structuring your accounts with your broker

Market Maker vs. ECN

How brokers handle negative balances

Brokers are large trading organizations… but some are not very sophisticated risk managers

Keep your account balances at a minimum

Be a risk manager first

Last week we experienced a “bang moment” when the SNB announced it was removing its currency peg.A “bang moment” is a statistically improbable event whose monumental effects are felt in a split second. If you’re not prepared, it is too late to do anything about it when it happens.“Bang moments” are a lot more common than you might think. Markets have what are termed “fat tails” when it comes to probability distribution. That is, things that statistically “should not happen” occur much more often than you would expect.Examples of long-tail events include the “black Monday” stock market crash of 1987, the events leading to the failure of Long Term Capital Management, the Japanese Tsunami, and last week the re-valuation of the Swiss Franc.In this somewhat technical article, I talk about how to prepare for “bang moments” in Forex, so you can avoid risks that have the potential to knock you out of the game, or with a bit of luck even allow you to profit.When a bang moment happens you face two types of risk.1. Market risk2. Counter-party riskMarket risk is what it sounds like. If the price goes against you, then you will suffer massive losses quickly, if you are heavily leveraged. It is perhaps the easier of the two risks to protect against.Counter-party risk is the risk of your broker getting into financial trouble, and you therefore not being able to access or withdraw your funds. In the worst-case scenario, you may lose them altogether. A recent high profile example of counter-party risk was the collapse of MF Global.With the proliferation of poorly regulated and undercapitalised Forex brokers, this is a big risk for Forex traders.I’m going to assume you use stop-losses to protect yourself if the market goes against you, so what I am going to talk about here is how to guard against the risk of the price significantly gapping though your stop-loss, like it did when the SNB removed the peg.Deep out of the money options allow you to benefit if the price moves a long way against you. For example the EUR/USD is currently trading at around 1.1600. If you brought a call option at say 1.2400 (which would be deep out of the money) that would give you protection from any move back above 1.2400. You might pay 10-15 pips or so for this protection for a couple of months.If you were to buy options that have a strike price close to the market, they can cost quite a bit. It’s because they are a long way from the current price that you can get them for cheap. Whether you are in and out, or holding positions for long-term moves, 15 or so pips should not break the bank.Exactly how many put options to buy will depend on your risk management objectives. The more “perfectly” you hedge your risk, the more expensive your hedge will be. If you want all your positions to be hedged, then it will cost more to buy the options, so perhaps you will hedge any position that is greater than the size of your account. It will depend on what you are trying to achieve in the long run.This strategy suits a scale-in approach if you are long-term trading. If your first position is small, then you may not hedge it, but as the trade moves in your favour and you add to your position, you can start to build a hedge. As the market has moved in your favour, the out of the money options will be cheaper meaning the cost of your protection is less.As short-term traders tend to trade with greater leverage, the tail risk can be greater. (Imagine if you had a large day trade on the USDCHF, and the price gapped against your position for 2000 pips). You will need to do some testing of worst-case scenarios, and consider how much risk you are willing to take when you structure your protection. It’s important to note that you can buy and sell an option pretty easily, but the cost of the spread is higher than on currency pairs themselves.When you are developing your risk management plan, it’s important to define how large a position you will have in any currency pair, or correlated pairs. You should also set the maximum amount of leverage you will use on your account.For example, you might allow yourself to have positions two times the size of your account value, with a maximum total leverage on the account of ten times your account value. You can add these considerations into how you build your option positions.How you structure your capital in your trading accounts serves two purposes. Firstly, it can protect against market risk, which I will explain below. Secondly, it can protect against counter-party risk (the risk of your broker going bust).There are a number of considerations to be aware of:The first thing to understand about structuring your accounts is the difference between a market maker and an ECN broker. It is during the bang moments that a “good” market maker can shine. As a market maker has the ability to create the price, they can fill your order even when it does not trade there in the inter-bank market.And some will do it.During 9/11, the Japanese Tsunami and the recent SNB intervention, some market makers filled stop orders without slippage. Meanwhile, those trading with ECN’s would have had to accept the prices from the pool of liquidity providers in the ECN. Generally, the market maker is a better choice in this scenario (though no guarantees!).Some brokers will tend to wipe any negative account balances that their clients experience (generally the larger market makers will be best at this).Why do this?Brokers are scared of the regulatory risk from negative balances. Did the client properly understand the risk that their account could go into negative balances when they opened the account? A broker never wants to be seen as shady, so it pays in the end just to eat the negative balance.It is this type of complaint that can threaten their long-term business. Even if the regulators will generally find in the favour of the broker, they would prefer not to have to deal with that risk. So, if possible, they will simply wipe negative balances. Again, no guarantees, but it is worth considering.(I hope this is not seen as too sceptical about brokers’ motivations. They do this out of a positive desire to help and protect their clients, too.)The third consideration to think about with brokers is that they themselves can end up holding large positions in currency pairs. This happens either through prop trading, or due to customers’ orders. Sometimes this is hedged, but other times it’s not.This means that some brokers, as we have seen, can find themselves in strife if their positions go south. Don’t put too much faith in your broker being staffed by good traders or risk managers.Taking into consideration these three factors, one strategy to minimise tail risk is to limit the amount of funds you keep with your broker, who should be a market maker with a track record of filling orders in adverse situations, as well as clearing negative balances.This does not mean you need to reduce your position size when you trade; it simply means you can use “notional funding”. The idea behind this concept is that you could have $5000 in your account, but still trade as though it were $50,000. You can be prepared to risk your capital, without having all of it in your trading account at any one time.A good approach is to keep just enough money in your account to maintain your trades, and make sure you don’t get stopped out (or margin called!). Any excess funds can be kept in a more secure (preferably government guaranteed) financial institution. You then transfer funds into your account as you need them.In the event of a move against you, like we had with the SNB announcement, your risk could be limited in three ways.1. You order could be filled even if the price does not trade at your stop-loss2. If your account does go into a negative balance, there is a chance it will be wiped3. If you broker goes under while you are using “notional trading”, you will have lost a small amount of trading capital, rather than your entire account.This is, of course, if you have the options in a separate account – with a different broker (which you should!).This is the type of trade you want; one where downside risk is constrained, and upside potential is unlimited.Over to you…“Bang moments” can happen at any time, and it is only the prepared that will be saved (or prosper!). Take the steps that you need to build a risk management plan that protects your trading account from tail risk before it’s too late.It will take discipline to apply your risk management rules consistently – to guard against risks that very rarely occur. But, I can guarantee you one thing. When the next bang moment comes, you’ll be glad you did.