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Risk of Negative Equity in Tail Events

The question has been submitted on numerous occasions regarding the risk of an account being completely wiped out. Even the risk of negative equity (losing more than what is in your account) in a tail risk event.

When talking about such a possibility the most recent event that comes to mind is the SNB (Swiss National Bank) event in January 2015. The move was caused by the Swiss Monetary Policy makers un-pegging the CHF from the Euro. This was a complete surprise to the market as the SNB announced, only days previous, they were not looking to allow it to free float for some time



This shock, aptly named SNBomb, created a lack of liquidity on the long side of the market causing it to gap and servers to crash. Banks and aggregators could not get the liquidity out fast enough causing the price to jump about 12%.

This gap caused some major issues for brokers in which some of their client accounts where drawn in to a loss greater than the balance in their account. To suffer this level of debit the account holder would have had a very bad leverage policy allowing high exposure on the market. So let’s break this down:



Let’s say a trader has $10,000 in their account and they placed a trade long on the EURCHF. We know the EURCHF gapped 12% or (~1300 pip) this means the trader would have had to have $77,000 exposure (not factoring currency conversion or any drawdown) to have the account balance come to $0. Table shows incremental results of loss with varying lot sizes.


That now aside, Brokers who did suffer client accounts entering negative equity had both an accounting and PR issue.


Accounting issue may not have actually been an issue!

Please remember most broker run traders on a b-book. This mean trades are not being taken by the other side of the market but remaining on the brokers PL. This means the broker has still won even though account holder has moved in to negative equity. The negative equity of the account holder is then simply a number that can be forgotten by the broker.

The brokers who would have been hurt are the ones who send direct to market like ECN and DMA brokers.


Don’t scare off retail traders.

Brokers do not want bad PR propagating through the community by chasing traders for their negative equity. So, it's better for them to turn a blind eye to it and promote their generosity for dismissing traders negative balances. Nonetheless it’s not hurting anyone anyway. Out of 75 brokers interviewed only 10 were going after negative balances in client accounts.

See here the link for


Broker reaction after SNB event.

Broker who will go after negative balances.


How to safe guard against these events!

Unfortunately, traders who make some very simple mistakes will tend to be the ones who are caught in these sticky situations. Traders should only trade what they know well. This means only trading pairs which have good; research, flow of information (news) and in-depth understanding of the countries policies. So trading a pair based purely on technical information is not an intelligent decision. To increase your probability of avoiding such events you should apply these three simple rules to your trading strategy:


Do not trade currencies which have Monetary Policy restrictions

Do not trade exotics

Do not use outrageous leverage

These criteria are in Jackson Capital’s overarching risk policy and as you can see we avoided the SNBomb. Other things we avoided where the Brexit, Scottish referendum and the pegging of the Swiss Franc.


Other risk protocols employed by Jackson Capital also include:


Max overall Leverage 5:1

Max Leverage per trade <2:1

Reduce leverage in possible tail events

Switch off all-to-gather in possible tail events

Place limit order stop loss on trades.


It is very important to be aware of all the risks which so many novice trades fall trapped. The Australian government has a fantastic website warning about these risks. This is a clear reason why you should engage with a professional when looking to invest in currency.


https://www.moneysmart.gov.au/investing/complex-investments/foreign-exchange-trading 


Tags:

negative equity

risk

accout holder

forex accounts

forex

SNB

Swiss Bank

Swiss National Bank

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