We’re all just one trade away from humility. – Marvin to Bud Fox in Wall Street.
Last night I’d just finished watching an Alfred Hitchcock movie (Frenzy (1972) – recommend it) when I checked my Twitter feed. It was in a frenzy (pun intended) about GBP – capital letters tweets and charts that indicated a big plunge. I quickly checked the prices, and for a second I couldn’t believe it – almost 600 pips fall in 1 minute in GBP/USD.
My second reaction was to see what lessons could be drawn from this event. Some compared this with the SNB debacle from January 2015 – I disagree with this point of view. That was a ticking time bomb, the only unexpected thing being that it contained a nuclear load (I wrote at that time about it, here). What happened with the British pound last night was a total surprise, of a kind not seen since the flash crash on 6th May 2010.
First lesson here is that unless you’re trading with a bucket-shop, you can’t rely on your stop-loss 100% of the cases. Even if you avoid trading around high risk events (central bank announcements, NFP), you’re still exposed to this sort of black swan events.
Second lesson, in order to survive these huge and sudden moves, you have to trade a size small enough that if the price gaps 10X your stop loss for instance, the account doesn’t get wiped out. To illustrate, let’s say your SL on GBP/USD trades is normally 50 pips. In yesterday’s event, you’d have gotten a 600 pips loss, or 12 SLs in one go. If you risk 5% per trade for instance, that would’ve meant 60% of your account gone in a minute.
Third lesson: play the probabilities. Trader A is always in the markets, with one or more trades open. Trader B has open trades only at certain times. Which one is more exposed to black swan events? You guessed it, trader A.
“My philosophy has always been to stay out of the market as much as possible. The less time I am in the market, the less risk I am taking. If dictated by market conditions, I’d rather make X percent having significant market exposure in only three months of the year than make the same amount while being in the market all the time.” – Mark Minervini in Stock Market Wizards by Jack Schwager