How To Avoid The Next Flash Crash

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What happened yesterday, Friday October 7th, surely took many market participants by surprise. But more than surprise, these sudden moves (which are most often over in a matter of minutes) are generating more frustration than anything else. “Flash Crashes” are not a dynamic of the past, they are by all means a by-product of modern FX market architecture so it has become essential that we learn how to survive the next Flash Crash.

“Did a bomb go off in London?” – industry veteran

The kind of market reactions we are seeing always more often during the past couple of years still startle the group of former dealers that from price makers are now price takers, trading from their homes, family offices or small funds. Yesterday I was talking to some industry contacts that have been around since before the Black & Scholes option pricing model existed, and the more common considerations were as such:

“Darn algos have done it again”
“There is no longer a 2-way market”
“This is what happens when you get a machine doing a man’s job”

If you are puzzled by their frustration, then maybe we need to remember that in the past two years there have been a rising number of “flash crashes” or “price spikes” where liquidity was nowhere to be found and predatory practices took over.

#1 GBPUSD, October 2016

cable

#2 EURCHF, December 2014

eurchf

#3 EURNOK, December 2014

eurnok

#4 NZDUSD, August 2015

nzdusd

#5 USDCAD, January 2016

usdcad

#6 USDMXN, February 2016

usdmxn

We have written about these “Black Swan” events before, and they are not disappearing anytime soon. The regulatory onslaught that followed the FXProbe has changed the internal workings of the FX market. Bank dealing and prop desks are simply not providing a 2-way market (which implies taking on directional risk, which is one of those practices that has been pruned) when the proverbial hits the fan.  The result is that when option barriers or large levels full of stop orders gets hit, markets gap more than we’ve been used to. In the past bargain hunters would emerge after 100 pips for example, whereas now there’s no liquidity to be found for 400 or 500 pips.

How To Survive a Flash Crash

While it may be fascinating to understand what goes on within top-tier banks & funds, we need to keep things practical. I feel for the traders that were caught once more on the wrong side of this move. As of Thursday October 6th, a large global FX broker reported the following positions of it’s clients:

ssi

So once more, retail clients took a beating. The practice of “fading” moves, going counter-trend just because “the market has to bounce” is getting more expensive than ever. In the occurrances listed above, with the exception of EurChf, all price spikes occurred in line with the prevailing trend at the time.  What does this mean?

Follow the trend, don’t fade it.

We keep repeating this to our clients in the Trading Tribe each & every day: from a retail angle it really is safer to trade in line with the trend, and let all that pressure help you. When stops & barriers get hit, and price goes parabolic, you will either be in the trade or flat. For sure, you will not be on the other side of the price spike.

But there is another practice that kills retail traders. It is also one of the main causes of financial asset bubbles. The misuse of leverage.

Use low leverage, and trade well within your means.

Leverage, unfortunately, usually works against traders that have limited budgets. But leverage is also a consideration for those traders that have deeper pockets but are still risking their own capital. On this side of the business, we all face the same issue: having a position in the market that allows for a decent profit, but isn’t so big that it jeopardises our entire account in the case of a loss. What I suggest is to keep your max risk per each core position between 0.25% and 2% depending on your risk profile, on the robustness of your trading strategy and the resilience of your mindset. For retail traders, position sizes should be more towards the lower end; for ex-bank traders, position sizes can be higher.

And this leads us towards the third practice that typically kills retail traders. Depositing the entire amount of risk capital with their broker. But as we have seen time & time again, between slippage, rogue events, black swans, system problems, that risk capital isn’t at all safe. What to do about it?

Use notional funding.

Only deposit 10-20% of your risk capital with your broker, and keep the rest in an interest-bearing account. That way, even if a black swan decimates your account, you will not be out of the game. Longevity, or survival, should be a top priority. Before thinking about the upside of trading, think about the downside and make sure you are always thinking about defence before offence.

Over to You

Back in the day, I was attempting to steer a client towards a bold bet on GbpJpy. A colleague of mine, referring to the bold trade call I had made, said “the cemetery is full of heroes”. But the client gave me the green light and we sold 4 Mln GbpJpy.  After about 15 minutes into the trade, we were sitting pretty 40 odd pips in the black. My colleague strongly suggested I call the client to reduce exposure. The client agreed, we closed 2/3 of the position and trailed the stop close by. After a few moments of doing so, price spiked up due to a UK market mover and rallied for the next two days.

I learned my lesson. And I sincerely hope you do too.

Learn from the mistakes of others

Learn from you own mistakes

Learn from the wizdom of others

Live to fight (trade) another day.

About the Author

Justin Paolini is a Forex trader and member of the team at  www.fxrenew.com, a provider of Forex signals from ex-bank and hedge fund traders (get a free trial), or get FREE access to the Advanced Forex Course for Smart Traders. If you like his writing you can subscribe to the newsletter for free.

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