Is it possible to mitigate huge potential losses?
Yes, it’s possible, it’s easy and you could definitely do that in all cases. The best way to mitigate large losses in the case of an extreme event is to do two things. The first one is to make sure that your positions will not hurt you financially or not devastate you financially. If for example the market does tank suddenly and there’s a sudden change in trend or you’re worried about your financial wellbeing, then you’re probably trading too aggressively. You might have too much money in the market and you’re using too much leverage or maybe your position sizes are too big. The first thing you need to do is calm your trading down, reduce your leverage and position size so that it’s not going to be a problem if it does happen. The second thing that you can do to mitigate that is to have systems or rules that will profit from it. If you’re only a long side trader, then think about having some short side exposure because if you’re just holding stocks on the long side when the market crashes, obviously you’re going to get hurt. But if you’ve got a system that has some short side exposure, even though the market is going up, that short side system will make a ton of money when the market collapses so that it can offset some of the losses on your loan portfolio.
If you want to think just specifically about your long positions and how to mitigate those huge losses in the case of a black swan event, you could have some sort of hedge or exit in place that will prevent it from being a problem. the issue is these typically tend to be expensive so like some brokers you can pay for a guaranteed stop-loss particularly CFD brokers. What they do is they charge you a percentage of the exposure and you put in a guaranteed stop loss then you will get that price. If the price gaps way down, they’re going to guarantee to get you out at that price. They’re basically selling you a put option so that if the price does drop too quickly you’ve got guarantee that you’ll get out. They’re not doing that out of charity but for profit.
You have to ask yourself, “If I pay for a guaranteed stop on every single trade, how much money will I be giving my broker for the occasional chance that might happen?” In my experience, a better way to manage the black swan risk or the catastrophic risk is to make sure that you’ve got different positions in the market that will profit if it goes up, sideways, or down. Don’t be aggressive on your leverage and manage it that way. Obviously, you can have exits and you can turn your system off if the market starts to collapse but this is not guaranteeing your profits. Let’s say I’ve got a trend following system, you might have a rule that says if the broader market drops by 15%, then close all positions, because something crazy is happening. If that’s a rule that you’re thinking of, put that rule into your system, back test it, and see if it improves the performance. We’ve had enough wild markets in the last 30 years that you can see whether that rule is going to help. Particularly with the COVID market just now in early 2020, and also with the global financial crisis in 2007, 2008. You can see whether that sort of rule actually helps but you can never truly eliminate all risk. You’ve got to make sure that these scenarios don’t blow up and don’t destroy your account. For you to make money and win the game of trading, you need to make sure that you stay in the game, not blow up your account and not use too much leverage. If all of a sudden this happens, the most important thing is to not get caught up.
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