Last week’s drama with the collapse in the EURCHF peg hammers home an uncomfortable truth: you can lose more in your account than you deposit.
Trading on leverage is inherently dangerous. Although an instant 20% move in a major currency is a once in a lifetime event, it goes to show just how quickly the markets can charge over alleged safety features.
Did placing a stop loss at 1.19 for an open EURCHF trade do any good last week? Not a bit! As soon as the market breached 1.20, it instantly gapped down 10%.
When markets go bidless, it means that there is no liqudity in the market. That’s jargon that means everyone is too scared to do any buying or selling. There literally is no price at the moment where anyone is willing to trade.
It was at 1.20. The next thing you see is 1.08 and the price falling fast.
I was fortunate enough to be awake at 3 a.m. when the proverbial cow-pie hit the fan. Although I’m an alogrithmic trader, I confess that my immediate instinct was to hop on the bandwagon and buy!, Buy!, BUY! all the Swiss francs that I could handle (when you go short EURCHF, you’re selling euros and buying francs).
Every inch of my body wants to go short with the $EURCHF collapse, but I run an algo system and I’m sticking to it.
— OneStepRemoved.com (@_OneStepRemoved) January 15, 2015
The way I coped with the urge was to IM a friend and pass a running commentary on the insanity. Posting on Facebook and Twitter also kept me busy. Basically, it was a strategy to keep myself wholly occupied and distracted so that I wouldn’t be tempted to jump in.
I’ve seen mega moves before and, more importantly, I know from experience how badly people can get hurt. My favorite war story from working as a broker was a wealthy client in Kuwait that opened an account with $250,000 the night before NFP. He went long on 100:1 leverage and of course the report was the complete opposite of expectations. The market gapped instantly and before his trade could close, his account balance was -$20,000.
You don’t read stories like this on the forums because… who on earth wants to go advertise their financial destruction on the internet? It’s embarrassing and, if we’re honest with ourselves, that person is probably doing everything humanly possible to not think about their situation.
Free insurance
The primary reason to trade with maximum leverage is because it’s like free insurance against devastating losses. You never know when a peg will go bust or the next 9/11 is going to happen.
Let’s game this out. You were long USDCHF on Thursday and there was no stop loss in the world that could protect you against an instant 10% gap. Consider two scenarios:
- You had a $30,000 account balance and were trading an institutional level of leverage like 5:1. That means your position value was 30k * 5 = $150,000. The instant gap created a loss of 10% * $150,000 = $15,000.
- You had a $3,000 account and were trading the “crazy” leverage of 50:1. The position value was also $150,000 and yields a $15,000 loss.
Now let’s talk about what happens in the real world. In the first sceario, the money is on deposit with the broker and you 100% have lost $15,000. It’s a guaranteed fact and you can safely kiss the money goodbye.
In the second scenario, you may legally owe the broker $12,000 (3k-15k=-12k). However, what is the broker’s likelihood of recovering the money? If you’re in the UK and you trade at Pepperstone in Australia, they’d have to sue you in an Australian court. The attorney’s fees alone would be several thousand dollars. And most convincingly, you probably don’t have any assets that the court could award to the broker.
Even if you are in Australia, think about all the bad PR hitting the forums when the big dog starts suing little retail traders. There’s almost no business-case for pursuing the negative balances of retail forex traders.
You’re going to see a lot of hooplah this week about brokers “forgiving negative balances.” It’s great PR and it’s the best way for them to play it. They know darn well that there’s almost no chance of recovering that money. It’s the best way to turn lemons into lemonade because the brokers lost an epic amount of money.
How to protect yourself
Chris Zimmer, the programmer here at OneStepRemoved, sent me this as soon as the day ended.
I was already on board with it but this recent event makes your method of pulling money out of FX accounts look very obvious.
I just checked and the USDCHF dropped over 1600 pips on that bar. That really hits close to home as we could have easily been Long that pair and something tells me any stop would not have been filled.
Trade on leverage and, for goodness sake, withdraw the money at regular intervals. Nobody can take it away if you don’t keep it in their hands.
I certainly got a shock after a profitable night trading the DAX post SNB to see one of my other managed accounts was down -15k. Fortunately the broker re-assessed and was contained to a very minor loss. Still it presents a great wake up call and reminder to do some emergency planning for some what if scenarios.
Wow, that’s a terrible story but with a less happy ending. Glad to hear your broker stepped in and helped you out.
Shawn, I am enjoying ready your analysis. But, my question is…why did these brokers (like FXCM and Alpari) not have a certain percentage of funds hedged/or invested in options in case of a catastrophic event?
The more appropriate question was why did they allow such high leverage on pairs where they should have known the liquidity was at risk of getting pulled. I’m surprised everyone isn’t rushing to lower leverage on EUR/DKK, which is very likely to have its peg break soon, too.
FXCM had 300 million in cash when the blow up happened, so they did have a rainy day fund. The reason they had to go begging to Jefferies was that the remaining 75 million wasn’t enough to meet its worldwide regulatory cash requirements.
The Alpari blow up really surprises me. They were famous for running a market making operation. I’m really interested to hear when/how they fell apart.
Great article and wise advice of pulling funds out of the margin account at regular intervals.
Thanks.
Thanks, Mario!
Agree with this Shaun, for as long as the high leverage is allowed, I will be keeping the minimum amount I need in my account.
I do think that the regulators will be coming after the high leverage though, in the not-too-distant future.
Let’s see what happens.
On brokers attempting to recover negative balances, I have heard that some have emailed clients saying that they are liable for the losses. Which of course is correct in theory, but I would imagine that the amount actually recovered will be miniscule.
I’d be stunned if the regulators didn’t go on the warpath. It’s hard to argue that brokers are safe offering the current leverage when this is the aftermath.
More than likely. It’ll be like any lawsuit if it even came to that. The plantiff only recovers a fraction of the nominal amount.
regarding sl will not trigger, is it because there’s no demand for a CHF pair?
and, for QuantBar: tried to email you.. should the EA be on a mt4 with vpn? i have my mt4 hosted on another signal provider’s server.. would that benefit the QuantBar EA too?
There’s plenty of demand. The problem is that it’s all one sided. Every transaction requires a buyer AND seller. It doesn’t do any good if everyone wants to buy francs.
The VPS is only necessary if you’re trading a decent amount of money. Otherwise, it’s pretty expensive overhead. I suggest using one if you already have a free option available.
Hey Shaun.. do you think FXCM will recover? And what will the CFTC do.. lower leverage too 10.1 in the US? If they do anything at all.
The terms of the $273 million loan either forces a sale or FXCM starts paying through the nose in interest. Articles like this aren’t going to do US retail traders any favors. http://finance.yahoo.com/news/swiss-shock-humbled-king-leveraged-110000362.html
Hey Shaun Just discovered you so the comment is a bit late. It was interesting that in the good old strictly protected UK Alpari customers accounts were frozen, liquidators saying all debts are expected to settled, will be pursued etc. And it’s likely to be some time before client’s money will be repaid
and quite possibly not in full, but either way there will be a few % deducted to cover admin fees. According to their last email, it might be quicker and easier to forfeit the money and lodge a claim with FS – 50k max. Thankfully FXCM stayed afloat and I didn’t have too much with Alpari but it’s dispelled the idea that a UK brokerage offers any better protection.
Absolutely. It’s not just the UK, either. Any jurisdiction is going to move like that. Bankruptcy takes years to process.
It’s not worth keeping more money in the broker than you’re comfortable losing. Leverage it to the max and keep your larger money in a safer place.
I can remember of what has happened to the CHFs last year. Its not the chf alone but my trader from Germany that traded for me and put so much heavy dosage of hedging against euro/usd. as the result I had to call Sensus to stop the trade and cancel the POA with that german trader. As result , the brokerage in Malta has fired the firm and referred to a trader in England and Sensus has terminated these relationship with US client. It is a once a lifetime thing when it comes to a CHF “china syndrome” meltdown. Can it happen again?? OH YEAH!!! Leverage is a dangerous thing unless it has been used in a proper way.
What about Guaranteed Stop Losses – for example with IG ?
There’s no such thing as a guaranteed stop loss if your account is over a certain size. If you are a small and if the guaranteed stop is written into the contract, then you’re fine. You’d better double check the contract, though.