DANGER: FLASH CRASH

Oct. 12, 2016

Apparently, black swans come once a year now.

I was always under the impression that black swans–unexpectedly traumatic events–were rare.

That’s what made them black swans.

Yet here we are.

In 2015, we had the out-of-nowhere plunge of the GBPCHF:

And then last Thursday (October 6, 2016) we had the flash crashing GBPUSD:

Both events came totally out of the blue, and both events moved well over 500 pips within minutes. One was in 2015. One was in 2016.

Back-to-back flashes in consecutive years.

Is this the way it’s going to be from now on?

Maybe.

If we go back and look at the major black swan moves since the Great Margin Call of 2008, we see that these events aren’t all that rare.

Unofficially, there was:

1. The Dubai debt standstill – November, 2009
2. Greece’s debt rating downgraded to junk – April, 2010
3. The Dow Jones Flash Crash – May, 2010
4. Swiss Franc falls down an elevator shaft – January, 2015
5. Chinese Stock Market Crash – June, 2015
6. GBP Flash Crash – October, 2016

That’s six big events in eight years. Not every year, but way too often.

So what can we do about it?

The first answer is nothing. Black swan events are a part of life. You can never avoid them, and you’ll never know they’re coming.

That’s depressing.

The second answer is to be ready for them. How do you do that?

Here are a few ways to be prepared for the unexpected:

1. Trade with robots. When these things happen, it’s very easy to panic. And panic is never good when the sky is falling. A robot, however, will handle a stressful situation like it handles any other situation. The outcome may not be great, but it won’t be worse than it was supposed to be. It’s the “worse than it was supposed to be” that ruins accounts.
2. Use stoplosses. I’ve gotten emails and texts from people who lost money during last Thursday’s meltdown. The common characteristic was that they were trading without stoplosses. IMPORTANT: I’m not saying that trading without stops is bad. It’s a great way to trade. But there’s no way to stop the bleeding if you don’t have a stop. Thursday’s GBP plunge was not on a gap (unlike the GBPCHF), so a stoploss would have been activated if you were long GBP. Yes, stops are affected because spreads go crazy during a black swan event, but a stoploss will get you out at some point. With a stoploss, there’s a limit to your pain. Without a stoploss, there’s almost no limit to the downside during a crash.
3. Trade with the trend? When the flash crash happened last week, I wasn’t in any trades because it was after my daily time limit (my robots don’t trade in EST evenings). But if the daytrading robots were trading at the time of the Crash, they all would have been short. Meaning: they all would have gotten a ridiculous profit had they gotten a trade signal. The reason, I think, is because they all go with the trend. They wait for a trend to be determined, and then go in that direction. My countertrend GBP robots, on the other hand, would have been on the wrong side of the GBP slide and been in a big hole. A black swan can get you no matter what style you trade, but maybe, just maybe, you can put the odds a little more on your side if you trade with the trend.
4. Use small trade sizes. Of course, if you trade small, the damage from any black swan will be small. That’s a smart way to keep yourself out of the big loss. And it’s also a way to handle a plummet if you’re not using stops.
5. Separate your accounts. If you do want to use a big trade size to try to grow an account, then separating your accounts is a smart move. It’s possible your stoploss will hold during an unexpected event, allowing you can go back to trading-as-usual afterward. If that’s the case, then fine. If the worst case happens, however, and one account is roasted, you would still have other accounts that are hopefully unaffected–and you can get it back. Separating gives you a chance at being more protected.
6. Diversify?? I tweeted last Thursday about the dilemma of diversification. When a Flash Crash occurs, diversification is a good thing, right? If you’re diversified across many instruments, then a crash to one instrument won’t bother you. Well, if you had GBP in your portfolio on more than one instrument (GBPUSD or GBPAUD or GBPCHF or GBPCAD, etc), then diversification didn’t help you at all. Not. One. Bit. If you just trade one instrument, though, your chances of being caught in a black swan are less. Sure, you might still get clipped, but the more exposure you have, the more chances you have of catching bad luck. The answer isn’t totally clear. But I’m comfortable focusing on just one thing at a time, and limiting my exposure.

The bottom line: You need to have a thorough plan for the worst case scenario. Remember, you can lose more than you put in. During a panic, your broker will try to get you out (if you use stops), but there’s no guarantee your stoploss will hold during a tumultuous move. It is possible that you could end of owing the broker money after the dust settles. That’s not good.

And the sad truth is that there’s no perfect way to protect yourself from black swans. The only true way to never get affected is not to play the game.

But the game is worth playing. So protect yourself as best you can.

And be careful out there.

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