Saturday, June 01, 2013

Dealing with major adverse price movements

Trading is not a one way street. Even if you have a robust, proven method, there will be unexpected roadblocks or obstacles put in your way. You will encounter all sorts of issues. To use one of my favourite sayings, you can only control what is controllable. You do not know what can occur in the future. For example, traders have no control over any of the following:

  • Unexpected market closures (i.e. after 9/11 the NYSE was closed for 4 days);
  • Unexpected power blackouts; 
  • Earnings surprises or disappointments;
  • Company takeovers or acquisitions (or the cancellation of);
  • Companies being delisted, or a dilution of shares already in issue.
Obviously some of these issues will depend upon what your timeframe is. For example, power blackouts could be an issue for a day trader or scalper, but not for a trend follower. Similarly, company announcements made outside of market hours are more of an issue for a trend follower or longer-term trader rather than a day trader.

However, in these examples, the end result can be a major price movement, which could go against you, causing significant losses either in open profits or in cash equity, with no chance to exit your position.

As always, prudent risk control can help you, but it will not completely eliminate the possibility of a loss far greater than anticipated from occurring.

When attempting to construct a risk management model, people need to be aware of these possible scenarios, and how they would effect them, both from a financial and equity point of view, but also psychologically. It is for no reason that a lot of traders risk no more than 1% - 2% per trade.

From my own experience, in 2008 the FSA here in the UK banned the shorting of certain stocks during the market downtrend. This included banking stocks, that I was already short. Overnight, there was a big gap up in those stocks, and I was stopped out of those short positions as a result. However, within a matter of days those same stocks were at lower levels than prior to that announcement.

Thinking further back, the day after the 1987 stock market crash, US government intervention meant that traders such as the Turtles suffered significant drawdowns. In his book Way of the Turtle Curtis Faith talked about a 60% drawdown, and the elimination of several months profit, overnight.

I will have more to say on this in the coming days.

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