Why Catastrophic Losses in Forex are Always Possible : A Look at the Forex Worst-Case Scenario

It is very common for people new to forex trading to consider that forex trading can be traded with little or no risk when adequate precautions are taken into account. However these people often miss to understand that the forex market is a high-risk playground for many reasons beyond the thousands of rookies who wipe their accounts everyday. Trading in general is considered high risk because there is always the possibility to have a total account loss, regardless of the use of a stop loss or other mechanisms that may act as a way to protect you from the market. On today’s post I will be talking to you about the worst-case forex scenario and why having an open position exposes you to an account wipe-out regardless of your protection mechanism and your money management. However you will see that such a scenario is – although possible – extremely unlikely.

The first thing we are told when we start our trading journey is that the stop loss is our way of protecting our equity from further loses. You start to think – Well, if price moves against me it won’t matter because I will never lose more than the SL – and for the bast majority of cases you are in fact right, a stop loss will protect your account from further losses since when price reaches the SL your order will be automatically exit. However you also have to realize that the SL is NOT a fail-safe mechanism and that there are particular occurrences when the placement of an SL will not guarantee the accurate exit of your position.

Why wouldn’t an SL work ? The fact is that a Stop Loss order merely tells your broker to exit at the first price that is equal to or worse than the value of the Stop Loss. This means that your broker is only able to execute the SL order on an existing price level which is generally not a problem since the forex market is for most purposes gap free. However if price decides to gap beyond your SL your broker will make you exit your position at the first available price worse than your SL which in some cases can be very far away.

The most common occurrence of this happening is when you leave trades opened through the weekend since this is where gaps are predicted to happen, however more often than not you will find that systems actually benefit from trading on Friday, even if you take into account “worse than expected” Stop Loss cases as additional loses (the seemingly “irrational fear” of over the week trading is something I will discuss later). However the absolute worst case is when gaps develop during the trading week due to very surprising news announcements. For example, an NFP release a few years ago made the GBP/USD gap a whole 200 pips during Friday. If you had been trading at the wrong side of the trade with an SL you could have probably experienced a slippage of 200-300 pips which could have caused a margin call if your risk management was actually very poor.

If you believe that you can avoid this by not trading important news then you are also wrong since black swan evens (rare unpredictable news or events like September 11 or a surprising rate hike during an emergency meeting) can also cause such gaps that will wipe your account. So the answer is clearly that whenever you have an open position, no matter what your SL is, there is always a certain gap that can develop that could potentially wipe you out.

The best way to protect yourself from this worst-case scenarios is to have several accounts and to use trading systems that aim to capture large movements. It would take a gap of more than 1000-2000 pips to wipe an account that risks 1% with a 100% ATR stop loss or a similar large value, such gaps have never happened and – even though possible – chances are that if they ever do they will signal an extreme and fast change in world wide conditions which – if adequate diversification is used – would allow you to exit with only a partial loss of your capital (just losing those accounts which have positions opened against the gap).

Many people would rather avoid the news and the weekends but in my experience and after careful evaluation this has had a negative effect on the performance of my trading systems almost all the time, even when taking into account “worse than expected” SL values. In the end news and over the week trading contributes some good signals in the long term that eventually lead to a loss of profitability when they are removed. So do not look at filters as answers, since this is the wrong way of approaching the situation but build systems that take into account these rare market occurrences so that in the long term their statistical meaning will not be very large.

If you would like to learn more about automated trading system design and how you too can make your own trading systems with sound risk and profit targets please consider buying my ebook on automated trading or joining Asirikuy to receive all ebook purchase benefits, weekly updates, check the live accounts I am running with several expert advisors and get in the road towards long term success in the forex market using automated trading systems. I hope you enjoyed the article !

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