Saturday, January 24, 2015

Have you calcuated your worst case scenario?

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.


  1. If you risk 20 basis points of your account per trade, which is common for a trend following approach, a -20R loss would impact the portfolio by 4%, which is not the end of the world. The problem with trend following stocks is the high correlation, which in a "Black Monday" kind event would hurt the portfolio pretty much.

  2. The worst case scenario (using trend following and spreadbetting) is either the spreadbetting provider going bust or ALL the positions that you hold dropping simultaneously to zero. Almost inconceivable but still possible. How much would you lose if this occurred?

    1. The major spreadbetting providers keep customer monies segregated in accordance with the FCA's rules on client monies. Any monies you have above the FSCS limits which are reversed for trading should be kept outside of the spreadbetting account in a bank account(or accounts), again up to FSCS limits.

      You can control your overall risk or portfolio heat by limiting the number of trades you keep open at any time. These days it is rare for me to have open more than half a dozen positions open simultaneously, because of the aggressive way I cut losing trades. As you say, the likelihood of all positions going to zero are remote (but technically possible) - if you are trading with the trend the chances are something going to zero would have you in a short position. There's generally a clue in the price action that may get you out of a long position, (such as the FXCM example above shows) before that happens.

      And, if everything simultaneously goes to zero, I suspect that trading would be the very least of our worries...