Hundreds if not thousands of traders, and their brokers, would have benefited from limited risk trading. On 15 January 2015, an astounding and unexpected move occurred in the currency markets; the Swiss National Bank (SNB) announced they would no longer protect the EUR/CHF 1.20 floor and subsequently the pair fell by over 30% in a matter of seconds.
The reason so many traders got burnt and a handful of well-known brokers were shut-down was because they held long (through buying) positions in EUR/CHF on the expectation that the pair would rise and when the pair suddenly dropped there was nothing they could do to protect themselves. In a regular market environment a stop-loss order is enough to limit risk or if you do not have enough funds in your account to support a move against you the trade will be automatically closed. In the SNB situation the market moved so fast and far that nothing could be done in time and no one in the world was able to trade at that time. Moments after the storm trades could be closed however by that point the price of EUR/CHF was so much lower if left many traders with extreme losses and even negative balances with their broker. Imagine, if you had held a 100,000 EUR/CHF buy position from 1.20 you would have lost 30,000 euros in a matter of seconds. This is an extremely rare event and usually when trading a deal of this size you would not expect to risk more than 1-5% (or 1000-5000 EURs).
The extreme losses surrounding this event may have been avoided if retail investors diversified their portfolio and hence diversified their risk. An instrument known as ‘vanilla options’ may be used to create limited risk positions. Furthermore, when buying options you do not require a stop-loss order to limit risk. This is because through buying an option you are buying a contract to trade your market view and pay a set premium for this. This premium is your maximum risk no matter what events occur next.
Let me explain this in more detail using an example: The day before the SNB event, a trader purchased a Call option contract and it cost him 260 EUR. The contract was an agreement that allowed the trader to buy 100,000 EUR/CHF at 1.20 over the next two-weeks. If the pair’s price had risen the trader would be in a preferential position holding a price that can beat the market. As we know, this was not the case and as EUR/CHF rapidly fell the trader lost the premium he paid, a mere 260 EURs. It is not until you compare this to the 30,000 EUR loss from the 100,000 EUR/CHF long trade directly executed in the market that you understand how significant this is. The losses from the option trade were over 100 times smaller!
This example, although under extreme market conditions, clearly demonstrates the possible advantages of limited risk trading when buying options to trade market direction. Read the article What is an Options Contract to learn more or open a vanilla options trading account here.
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