An Example of Overnight Risk
I have often mentioned that I prefer to day trade because it has lower risk. With futures there is a definite risk to holding positions overnight or through the weekend.
Here are 15 minute charts for Dec Corn (2010) on 7, 8 and 11 October, 2010.
On 7th November, you can see price opened around 493 and closed around 498, after flirting with the 500 mark. Imagine 4 traders with open positions at the close.
Trader A: Capital $10K, Long 2 contracts @ 500
Trader B: Capital $100K, Long 2 contracts @ 500
Trader C: Capital $10K, Short 2 contracts @ 500
Trader D: Capital $100K, Short 2 contracts @ 500
Traders B & D are better capitalized, but, being conservative souls, they are still only trading 2 contracts. That means their leverage is much lower than traders A & C. (Note that the margin for corn was around $2K, so even traders A & C could have been trading 4 or 5 contracts!)
Suppose all the traders had conscientiously entered GTC (good till cancel) stops 5 points from their entry positions, limiting their expected maximum trade risk to $500 plus commissions.
At close of play on the 7th, Traders A & B were about $200 down when the market closed at 498. Traders C & D were $200 up. (The corn contract is worth $50 per point and each trader was holding 2 contracts.)
Before the open on the 8th, the US government issued a report which surprised the market, indicating that corn was in much shorter supply than had been thought. The market opened “limit up” at 528.25 (the corn market has a limit of 30 cents movements in any normal session), and it remained locked for the entire session with no trades executed.
That was a Friday, so our Traders headed off to enjoy their weekends. Traders A & B were on top of the world – from being $200 down on Thursday night, they were now around $2,800 up! Traders C & D were besides themselves with worry, they could scarcely sleep or think about anything else, although Trader D was reasonably confident he could survive.
You see, their stop loss orders at 505 hadn’t fired, as no trades took place in the locked market, and now the price was sitting at 528! Poor old Trader C had logged onto his broker’s web site to find all his accounts highlighted in red and frozen, with urgent margin calls from his broker!
When Monday came round, all the traders were watching the market keenly. The exchange had expanded the daily limit from 30 to 45 cents, but they were all acutely aware that the price could sometimes move limit up (or down) for days on end!
That didn’t happen – not quite. The upper limit for the day would have been 573.25 and the market opened at 570. Let’s assume Traders A & B grabbed their profits at the open, and the stop loss orders for traders C & D were also filled at the open.
Traders A & B each gleefully pocketed $7K, the same amount that was lost by traders C & D. The percentage returns (ignoring commissions) are as follows:
Trader A: +70%
Trader B: +7%
Trader C: -70%
Trader D: -7%
Trader C: -70%
Trader D: -7%
Trader C is virtually out of the game. He’s likely to withdraw his remaining $3K and skulk away from the markets with dire warnings to all and sundry about futures trading being a fool’s game. (If he had been reckless enough to be trading 3 or 4 contracts, he would have ended up owing money to his broker!)
An experienced observer might comment that Trader A is a lucky person, but Trader D is a smart one. By trading conservatively, Trader D has weathered the storm and lives to fight another day without a crippling blow to his or her trading equity.
This is not meant to frighten or discourage you, although it should emphasise the need to thoroughly understand the risks before you enter futures positions. This real life scenario, where price “gaps” way beyond your stop loss point, is much more likely to happen while the markets are closed.
It seldom occurs while the markets are in session, so a day trader who is “flat” by the end of each session is far less likely to be hit than longer term traders. S/he may certainly experience slippage, sometimes severe slippage, but never 70 cents worth!
Also keep in mind that this example is taken from the relatively "quiet" corn market. It could also have happened in soybeans, where the daily limit is 70 cents, and expands to 105 cents after the first limit up day!
This is why we prefer trades which often last just a few minutes, so our exposure to the market is minimised even further. For the vast majority of the time, our money is sitting on the sidelines in a cash account.
[If you do get caught on the wrong side of the market in limit move days, there are some things you can try.
1) You might be able to get out during the (thin) electronic after market session, but don’t count on it.
2) Alternatively, remembering that although the future market is locked, the option market is still open, you could, in theory, protect yourself against further loss (for example, when the market was locked on Friday, you could have bought at the money call options. But don’t get excited, the option premiums will be sky high and you’ll still face a substantial loss.]
Excellent Post! Should be required reading for everyone who trades futures!
Comment by Derek — January 20, 2011 @ 5:48 pm