Home > Reducing the Risk of Catastrophic Trading Losses (It Happens! Are You at Risk?)

Reducing the Risk of Catastrophic Trading Losses (It Happens! Are You at Risk?)

Risk management and/or stop loss orders aren’t always effective, which could mean bigger losses than expected. See why and how you may be risking more than you think. See real-world examples where short-term traders got annihilated. Then, see how to reduce the chances of it happening to you.

This article is not intended to scare people away from trading. I trade and love it. Rather the article is intended to point out potential vulnerabilities in your risk management strategy.

People are drawn to trading because of the profit potential the financial markets offer. Stocks, forex, and futures can create financial independence or an extra stream of money, but they can also produce catastrophic losses. New traders should be aware of the profit potential a well-researched and practiced trading method can provide (see Swing Trading and Day Trading Profit Potential), but must also be aware that an entire account (or even more than they deposited) can be wiped out by unforeseen events…even with a risk management strategy in place.

This article takes a look at events that most traders didn’t expect, and that could have potentially cost them huge sums of money even with a stop loss order in place.

When Stop Losses Are Ineffective

For day traders and swing traders, the primary risk management tool used is a stop loss order. It is an order that gets a trader out of a position if they lose a certain amount of money on a trade.

Position size is another element of risk management. Position size is how many shares you take on a given trade (or how many lots in forex or contracts in the futures market).

The stop loss and the position size are combined to form a risk management strategy, where if the stop loss is hit, it only results in the trader losing 1% or less of their trading capital. In other words, professional traders typically don’t lose more than 1% of their trading capital on a single trade.

Most of the time, using a stop loss and keeping expected risk to less than 1% works fine. The trader is able to get out of the trade when the price of the asset hits the stop loss price and the loss is contained to a very small percentage of the trader’s account balance.

There are times when a stop loss is ineffective, though. The trader may not be able to get out of their position at the stop loss price, and instead, may end up getting out at a far worse price. Instead of losing 1% of their account, like they expect, they lose 3%, 10%, 20% or even 200% of their account balance. Losing 200% of the account would be highly unlikely, but could happen (as shown by real-world examples below), and would mean that the trader lost all the money in their account, and also has a large debt to their broker to cover the trading losses.

This does happen! It happens when the price of an asset doesn’t have liquidity at the stop loss price.

In order for a transaction to occur in the financial markets (like getting out of a trade) someone needs to be willing to take the other side of your trade–to buy when you are selling. If there is no one there to transact with you at the stop loss price, the stop loss order (which is typically a ‘market order’) will find the nearest price where someone is willing to transact with you. At times this can be very far away from your stop loss price.

An example would be buying a stock at $50 and placing a stop loss at $49. The trader is expecting the price to rise, but if it doesn’t their stop loss will get them out of the trade at $49, limiting the loss to $1 for each share they own. But assume the company declares they are facing financial hardships during the night (when the stock market is closed). No one is going to want to buy that stock the next morning (at least not at anywhere near $50) until they know more about what is going on. That means the highest bidder (someone willing to buy) may be at $20. At $20 is where the stop loss order will fill. Our trader who bought at $50 thought she was only risking $1/share, but ended actually losing $30/share. That’s a 30x bigger loss than expected.

This is called a price gap. It’s when the price trades at a different price from one day to the next, with nowhere for people to exit (or enter) between the two day’s prices.

 

Gaps are common in markets that close in the evening and then don’t re-open for trading until the next morning, such as stocks. Any news that comes out overnight can impact what buyer/sellers are willing to buy/sell the stock for, potentially causing a significant price difference from one day to the next. Many stocks don’t see gaps overnight, but many others do….and sometimes they are big.

The inability to get out of a position at the price you want can also happen during the day, while day trading or swing trade. As mentioned, to sell you need someone willing to buy from you, and to buy you need someone willing to sell to you.

Let’s say you take a day trading position and go short 1000 shares in a stock at $25.63. This means you sell first, expecting the price to drop. You then need to buy to exit your position. By looking at the bid/ask prices for several price levels (called a Level II) you can see that there are about 1000 to 2000 shares for sale at each cent above $25.63, up to $25.70. Based on this, you decide that if the price rises to $25.68 you will exit your position, for a $50 loss (1000 shares x $0.05).

You have a 1000 share position and that should be easy to get out of since there are people willing to sell about 1000 shares at every price level within $0.07 of your entry price. It is the middle of the day, nothing is going on and no major news announcements are expected. All of a sudden someone else buys every share for sale all the up to $25.90, and then posts a bid to buy more at $25.90. The bid price is now $25.90 and the ask price is $25.91. You needed to buy to get out of your position, and you were hoping to do that at $25.68, but someone else bought all the shares available (up to $25.90) before you had a chance. That means the next available shares for you to buy are at $25.91. You can choose to get out there and take a loss of $0.28/share ($280 hit instead of $50), or you can choose to wait. Maybe the price will drop back and you can reduce your loss, but it could get worse if people keep buying and pushing the price up further.

Traders often think there needs to a news-related reason for their big losses. That is not true. Like in this latter case, it could just be that someone wants to buy/sell a large quantity of shares (or lots in the forex market, or contracts in the futures market), and so they buy/sell all the shares within a price area. If someone else is trying to do that same thing, it is the first person to do it that gets the shares. Once the price has moved it is too late, everyone must now accept the new price and transact there, or wait for a different price.

Examples of Market Moves That Annihilated Traders

Such events may seem rare. They are not. Big moves occur every day causing day traders to lose more than expected, and price gaps are a common occurrence in a significant number of stocks each morning. Minor examples of this happen daily, but significant examples (which likely hurt thousands of traders at one time) are also more common than most people think.

On October 7, 2016, the British Pound (GBP) dropped 620 pips against the US dollar (USD) in minutes. This occurred during a “quiet time” in the 24-hour forex market, after the US market closed. There were likely few day traders in the pair at the time, but if there were they may have gotten hammered. Day traders will often risk 5 to 10 pips on a day trade. During this Oct. 7 event, it is likely they would have been unable to get out before the price had moved 200 pips or more against them (if they were long before the surprise ‘flash crash‘). In other words, they were trading along and minding their own business, with nothing to indicate a big move was coming, and then instead of losing 5 to 10 pips, they lose 200 pips, which is 20x to 40x the amount expected. If risking 1% of their capital on the trade with a 5 pip stop loss, this trader could have lost 40% of their account in a minute. If they had risked 2% of their account (meaning they had double the position of a person risking 1% of their account), they lost 80% of the account in a minute.

Swing traders, with a stop loss of 100 pips or so, likely lost double or triple what they were expecting (which is not catastrophic if only risking 1% to begin with).

GBPUSD flash crash on October 7, 2016
GBPUSD Flash Crash, 5-Minute Chart, October 7, 2016

The following are other publicized events where large groups of traders got hammered. Remember, these events were surprises, meaning they were unexpected and therefore caught a lot of traders in their wake.

January 15, 2015, the Swiss franc (CHF) moved over 1840 pips in a single day against the USD when the Swiss Bank abandoned its policy to hold the Swiss franc at a certain value against the euro. Typically, prior to the big move, the USD/CHF moved a bit less than 100 pips per day. After the massive move, many traders had huge deficits owing to their broker, and by extension, several forex brokers faced solvency issues themselves because so many of their clients had negative account balances.

Major losses also occurred in the EUR/CHF, which plunged more than 2800 pips in a day, and typically only moved about 20 pips per day leading into the CHF surge (euro drop). Traders were buying EUR (selling CHF) above where the Swiss Bank said they would hold the rate. When the bank abandoned this policy, the euro plunged. According to Oanda sentiment at the time, about 98% of traders were buying EUR. That means that 98% of traders with trades in that pair faced massive losses on the euro decline, while the 2% of traders on the other side of the transaction (buying CHF) saw a windfall profit (potentially, depending on where they got out). In other words, nearly every trader that was in a EUR/CHF trade lost WAY more than expected. Once the bank abandoned the policy, no one wanted to buy euros anymore (and everyone was forced out of their positions by selling the euros they already owned) which meant very little liquidity as the EUR started to drop. Traders were forced to sell those euros at worse and worse prices if they hoped to get out.

EURCHF Crash January 15 2015
EURCHF Daily Chart. Crash (CHF Surge) on January 15, 2015

These examples include some of the biggest currencies in the world. Such moves are not limited to highly speculative or thinly traded currencies. Moves like this also occur in stocks and other markets are well.

August 5, 2016, Bristol-Myers Squibb (BMY) is trading near a multi-year high, closing at $75.32 on Aug. 4. The next day it opens at $62. This price gap occurred overnight, so day traders wouldn’t have been hurt, but it is highly likely many swing traders were. Some swing traders likely had stop loss orders just a bit below the August 4 closing price. Instead of only losing a dollar to two per share, they ended up taking more than a $10 hit on each share they owned. The drop occurred when it is was revealed that a BMY cancer drug had failed one of its clinical trials. The stock continued to drop, trading as low as $49.03 on October 25, showing that holding onto a losing position in the hopes it will come back isn’t always a viable option.

Gaps like this occur every day in the stock market. Finviz shows a daily list of stocks that have had big gaps up or down.

BMY price gap August 5 2016

August 24, 2015, June 24, 2016, the SPDR S&P 500 ETF (SPY), one of the most heavily traded instruments in the world, saw significant price gaps from one day to the next. August 25, 2015, was a Monday, and the ETF opened at $187.49. It had closed the prior Friday at $197.63. At least, in this case, the price had been falling aggressively in days prior, so there was a warning that the price was under strong downward pressure.

June 24, 2016, saw SPY open at $203.63. The prior day it had closed at $210.81. Those are significant moves for one of the most heavily traded financial vehicles in the world (and that reflects the movements of 500 of the USA’s largest companies). On both these days, many individual stocks saw much larger price movements, causing many traders to lose much more than they ever fathomed in a single day.

These are but a few of the events where many traders saw big losses. Similar stories occur each day but typically aren’t widely reported since they don’t impact a large group of traders (but the traders involved feel very impacted!). Some of these big moves are anticipated, while others are surprises. Here are some guidelines to help you reduce your chances of catastrophic loss.

Ways to Reduce the Risk of Catastrophic Trading Losses

There is no way to totally eliminate the possibility that you could lose more than you expect [except when investing, where you can invest a percentage of your investment account in each stock you own. That way, the risk of the individual stock is the limited to the percent of account capital invested in the asset. For example, if you buy $3,000 worth of one stock in your $100,000 investment account, your loss on that stock is limited to 3% of your account. This approach doesn’t typically work well with swing or day trading because to utilize all your capital you need loads of trades going at one time, and because they are short-term trades, commissions will likely eat up all gains made on all these small trades]. Sometimes you just can’t get out of a trade at the price you expect. This can happen whether you are a day trader or swing trader.

The examples above show that big price moves–where you can’t get out at the price you want–occur in major companies and assets, not just obscure highly speculative companies or currencies (such moves tend to occur in obscure thinly traded assets more frequently, though). While big losses can occur anytime, anywhere, there are some things you can do to help minimize your chances of losing a huge chunk of money on one trade.

  • When day trading, close out all positions before scheduled high-impact economic news events or company announcements (for the stock you are trading) such as earnings or conference calls.
  • Avoid holding swing trading positions during a company’s earnings announcement (use Options instead, since when you buy an option you can only lose what you pay for the option).
  • Avoid swing trading companies that are prone to high-impact news at random intervals, such as pharmaceutical or biotechnology companies. If you see lots of big gaps on a price chart, that is usually a good reason to stay away from swing trading that stock. There are lots of “gap strategies” out there. Those are fine, since the strategies are typically taking trades after a gap has occurred. I have nothing against trading gaps (if you have a viable method for doing so) after they have occurred. It is holding positions in assets that tend to gap that is a more dangerous business.
    • If you want to buy a stock like this (prone to gaps on drug trial results, FDA approvals, etc), wait for a price good price and invest in the stock. This way you can allocate a small percentage of your account to buy shares. For example, if you have a $100,000 account, you could allocate 3% of your capital to that stock, buying $3000 worth of stock ($3000 divided by the share price tells you how many share to buy). This way, if a bad scenario occurs, the absolute most you can lose is $3,000, which is a small percentage of the investment account.
    • Focus on swing trading stocks that have consistent price movements that you can capture over and over again. There is no need to gamble on earnings or drug trial results. While you may occasionally get lucky, you can also get hammered.
  • Day trade stocks that have lots of shares available at all price levels. This helps reduce the chance of slippage (getting a worse price than expected). Slippage can’t be totally eliminated, but it is much more likely to occur in stocks where there are few buyers/sellers to transact with.
  • If volatility is really low, watch the position size. When prices are not moving very much, traders often bring their stop loss very close to their entry point. In theory, they can then take a larger position size, while still only risking a small percentage of their account. But a quick rise in volatility could mean a bigger than expected loss on that larger position size…like what happened in the EUR/CHF, where traders were taking big positions to capture small moves. Avoid ramping up position sizes too much in quiet conditions. Be okay with making a little less in such environments, as holding too big of a position–if volatility spikes–can be catastrophic.
  • For swing trading, keep risk on a single trade to 1% or less of trading capital (absolute maximum, 2%). Day traders should ideally be risking less than 1% of their trading capital on a trade. With a decent sized trading account, 1% can be a large chunk of money, so many professionals risk less than 1% of their account on each trade.
  • Gaps can occur against the trend direction (like in the BMY example above) but typically traders are better off trading in the trending direction. If you are always buying as the price of an asset is plunging (or shorting as the price is surging), you are more likely to find yourself in scenarios where the price could gap against you. While trading in the trending direction doesn’t eliminate the chance of a significant loss, it makes it less likely, assuming you also follow the guidelines mentioned above.
  • Avoid taking trades where it seems like “easy money” and “everyone is doing it.” If nearly all traders are on one side of the market, that means you only have a few massive traders are on the other side of the trade (and massive traders don’t become massive by making poor decisions). This was how to avoid the EUR/CHF massacre. You had to rationalize that if a large group of traders is forced out of the trade at once, it will be like a dam breaking…you may not get out of the way in time. Everyone is taking any available exit they can find which means it is very likely a large group of traders will not finding opposing orders at a price they want, and will be forced out at a way worse price than expected.

Hopefully, you will never experience a huge trading loss. And it may seem like a remote possibility that it could happen to you. Yet, every day I get emails from different traders who have lost everything and are seeking guidance on how to rebuild. They didn’t think it would happen to them, but it only takes one bad decision, or just being in the wrong place at the wrong time to lose a lot of money in a hurry. Typically I provide the guidelines above, depending on the situation. Don’t be in that position….looking for ways to reduce risk after you have lost everything. Be proactive in managing your risk. By being proactive with the guidelines above, you are less likely to be in the wrong place at the wrong time.

Of course, not all trading losses are due to market movements. Sometimes traders lose everything simply because they refuse to get out of losing trades (loss aversion), don’t have a viable strategy, or hit a losing streak and are risking way too much on each trade. That is a different story. This article is meant for traders who have a viable strategy and decent risk management, but want to better protect their capital from scenarios like those discussed above.

And yes, there is a flip to this. When someone takes a huge hit, someone else profits. The longer you stay in the trading game and avoid taking those massive hits, the better your chances of ending up on the winning side of big price moves.

The Final Word – Trading IS a Risky Business

If you trade stocks, forex or futures, there is always a risk. While many traders go their whole careers without taking a monster hit, many traders experience at least one at some point in their career. I feel it is important that traders know the upside of day and swing trading, but also the risks…there is a chance of significant losses even with a risk management strategy in place.

It is not always possible to liquidate a position at the price you want, which means you could take a much bigger financial hit than expected on any given trade. Take this trader for example, who lost everything in his $37,000 trading account, and ended up owing his broker more than $100,000 on top of losing his own capital.  Such massive losses are definitely not the norm among day and swing traders, and had the trader followed the guidelines above the loss would not have occurred (position size way too big for the account, and biotech/pharma stocks are not recommended for most swing traders). But it does happen, and the trader never thinks it will happen to them….and that is the lesson. These big hits do happen, and they happen to real people… sometimes as the result of a poor decision, or even a good decision (or so it seemed at the time).

This is not meant to scare people away from the markets. I have been trading since 2005 I have yet to take a catastrophic hit. But I have taken many losses that were larger than expected.

Catastrophe is more likely to be averted if you stay out of day trades right before news, avoid swing trades right before earnings, and avoid assets that are prone to surprise news and gaps. Day and swing trade assets with high volume, so you can (typically) liquidate your trades with ease. And always keep your position size in mind. Even if your position size adheres to your risk management strategy, if a gap were to occur would you be wiped out? If so, you are trading too big. Trading isn’t just about the profits. Profits will come if you have a solid method. Trading is just as much about avoiding the big losses.

When someone takes a huge hit, someone else profits. The longer you stay in the trading game and avoid taking those massive hits, the better your chances of ending up on the winning side of big price moves.

By Cory Mitchell, CMT

 

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