Pitfalls in Measuring Risks When Trading the Markets
I think it’s safe to say that more money has been lost through the wrong measurement of risk – which gives one a false sense of security – than by failure to measure risk at all. To provide an analogy, it would be safer to drive a car without a speedometer than a car with a speedometer which understates the true speed by 25%. If there was no actual gauge of the speed, you would be conscious of that absence of information and as a result, would take extra caution. If instead, you are relying on a speedometer that shows 60 kmph when in fact the true speed is 75 kmph or higher, then you will be more prone not only to speeding tickets but accidents as well.
Similarly in trading, relying on risk measurements that significantly understate true risk may be far more dangerous than not using any risk measurement at all. The most recent example to illustrate this is January 15th’s SNB debacle.
The constant assurance of the Swiss officials that the EUR/CHF peg was there to stay, coupled with low margins for CHF pairs offered by brokers who should have known better led to hundreds of millions in aggregate losses.
Would there have been so many traders affected had they not listened to officials talking their book? Would there have been so many brokers affected – I’m looking at you FXCM – had they raised margins accordingly for a currency, which was no longer free floating? I think everyone would agree the answer to both questions is a resounding NO.