Central Banks Go Wild? Trading Mistake #50

Why You Can Go Broke When Central Banks Go Wild?

Unless you just started trading 2 days ago, you must have heard about the latest Swiss National Bank (SNB) tornado. In fact, you don’t even have to be a trader to be aware of the fact that the Swiss Franc strengthened tremendously against the Euro and other counterparts when the SNB decided to remove the floor which was artificially in place. The article linked at the bottom contains a brief explanation of what happened, but here I will show you my way of protecting my money against such an event.

To be honest I will leave the complicated economic talk to analysts and economists with years of high level education under their belts. I will not fill your head with opinions about why the SNB did it, how they did it and whether they should or shouldn’t have done it. Honestly, I don’t care about the reasons, just about how I can avoid blowing my entire account… not to mention owing money to my broker. By now we all know that a Stop Loss doesn’t help much when the SNB or any other Central Bank drops “bombs” so we must have other type of protection in place. Keep in mind; the scenarios described in this article apply only to events similar to the recent SNB “hurricane”. Ok, I want to keep it short so let’s get to the point: there are two parts to this protective strategy.

 

Why Negative Balance Protection is a Must?

First you need to trade with a broker which offers Negative Balance Protection. This is a must and from now on, I will never trade with a company which doesn’t guarantee this protection. Hypothetically this is what happens: price goes against you, the Stop Loss is hit but due to lack of liquidity it is not executed so the loss continues to increase to the point where normally a Margin Call would stop the trade (usually when only 20% of the account is left, but it depends on the broker). Unfortunately the Margin Call cannot be executed due to the same lack of liquidity and now the trade is eating up your last piece of the account. You start accepting that you are going lose it all and that your account will soon show a Zero balance… but that’s not the case, because the same lack of liquidity will make it impossible for the trade to close at zero. So your account will enter the dreaded “minus” territory. That means you owe money to the broker and they can sue you for your $$, depending on the Terms and Conditions which you signed. Not only you lose your account, but you have to reach down your pockets to pay The Man. Talk about a s#1tty day, eh… But there is hope, don’t worry: if your broker offers Negative Balance Protection – the real stuff, not just fake, marketing promises – then everything below Zero is covered by them, meaning you can NEVER owe money to your broker (oh well, unless you break the law or something). Worst case scenario, you lose your entire account, but that’s it, you don’t have a negative balance which you need to pay. And this takes us to the second part of the strategy – yea, I think I’m gonna keep calling it a strategy.

 

Conclusion: Don’t Keep All Your Eggs in One Basket

For the purpose of this explanation let’s assume you have a $10,000 account. What you need to do is withdraw $5,000 right away, or if you haven’t deposited yet but you want to, just deposit $5,000 (half of the money you want to invest). All your trading, position sizing and money management must be conducted knowing that you have $10,000, not $5,000 and actually that is the case, just that you don’t have them all in one place – half is with your broker, half is in your pocket). If during normal trading you need the rest of the money, you can transfer them into the trading account. These days deposits are almost instant so that shouldn’t be a problem. Now let’s go back to the worst case scenario: assuming you are trading with a Negative Balance Protection broker, you cannot lose more than you have in your account. And how much do you have? Half, 50% of the actual sum you use for trading. The other half is sitting safely in your pocket. Now reach down the pocket, feel the other half of the money and know that you just dodged a financial bullet by getting out with 50% of your balance while others now owe money to their broker.

This type of money management could raise some issues concerning margin requirements, especially if your trading is not very profitable, because if you only have, say $1,000 left (out of the initial 5K), you cannot trade it as if that 1K were 10K. But anyway, that means you need to improve your trading skills and that’s a different discussion altogether, but I guess now that you know how to go from owing money to actually preserving 50% of your capital, you are a better trader already. You’re welcome!

 

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