In the aftermath of the EUR/CHF debacle, I contacted a few traders who I've corresponded with in the past to find out if the events of the preceding few days had caused them to look at their own trading, and consider any changes to their risk management.
Almost to a person, they said no - their risk approach was robust enough to deal with such an event. This was reassuring to know, not only because I had come to the same conclusion myself, but because nearly all of them utilise a trend following approach, and risk control is an integral part of such a method.
However, I did look to try and quantify what sort of effect this event could have created in my own trading.
One of the stocks most affected was FX brokerage FXCM, whose chart I've shown below. Had you been holding a long position in this stock, what effect on your account would the sudden drop have?
Even though based on my rules I would not be holding a long position in this stock (in actual fact, my rules would have given a short signal a couple of days prior to the big drop), I've assumed for the purposes of this example that I have entered long at the high on 05 January, which was the high of the year to date.
Based on my position sizing calculations, which is based on a volatility measurement, 1R would have equated to $0.90. The difference between the high of the year and the low of 20 January equated to $16.09. Given our position sizing metric - that huge fall would have led to a loss of almost -18R.
Could you live with such a drop? Have you done similar calculations based on your own approach to risk?
While this drop was tied to a very specific market event, you may have the misfortune to suffer from a huge gap like this on an earnings miss, a surprise takeover announcement (if you are short), or some other unexpected event. So you can never say it will never happen to you.