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Broker Risk

07/17/2012

Only risk 1-5% of your account on any given trade?  Anyone ever heard this statement before?  It’s pretty much a staple in the trading industry. You need to follow some sort of similar money management strategy or risk blowing your account.  Heck, I’ve written blogs on this topic in the past.

Well, it’s a wrong strategy – at least for the private trader with any sort of decent equity in their trading account.

What?  What are you saying?  That you need to risk more than that to make money?  Less than that? I don’t think I agree with you and I sure don’t understand.

Well, that’s why you’re reading.  (and that’s why I write provocative things) I don’t expect everyone to agree with me.  I write for an audience of one, discussing what works for me.  I hope others gain benefit from my insight, but as with everything, you must pick a system that works for you.  I’m still here a few years later, so something must be working out though.

I always bought into the philosophy that if you risk a small percent of your account on a trade, you will always live to trade another day.  You can never truly “blow” your account with this math (though you can get progressively closer to zero if you don’t know what you’re doing).  But, lets look at this a different way.

When we calculate our risk profile as traders we often make unstated assumptions.  We assume our trades will be executed correctly.  We assume our stops will be honored (pretty much).  We assume we can control our downside risk with proper precautions thereby insuring a maximum possible loss on any given position thereby managing the negative exposure of our account.  We also know we don’t need to use stop losses and can learn to manage our positions in real time if we want to.  We have plenty of risk management options, but there is one really big one that up until recently we thought wasn’t that much of a concern.

Back in the good old days when US customers could easily open forex trading accounts in other countries traders knew there were associated risks with doing so.  Sure, Australian companies were probably safe, but how about one in Madagascar or Belize?  Can you really trust a broker who offers 500:1 leverage?  Well, only so far as you can trust your own trading, but I digress. (ps, you can still open accounts overseas if you really want to, but I’m not sure the benefits really outweigh the hassle).

The risks associated with these non American brokers are obvious, aren’t they? It’s difficult to verify their capitalization.  You don’t know if they actually segregate client’s funds.  You don’t know if they “trade against” the client.  Heck, you don’t know if they take the client’s money and trade with it for themselves.  If you’re part of the 4%, you don’t know how long they take to process your withdraw request after you’ve made your 30% for the month.  They don’t have the FTC, and the NFA and the CFTC and the FED and the ATF and NRA and KFC all looking after them to make sure they stay in line.  Therefore, you can’t guarantee the security and liquidity of your account.

Wait, hold on a minute here. What brokers were we talking about?  US ones, or shady third world brokers.  I don’t remember.  Eh, six of one as they say.

And that’s the unstated assumption traders make when they trade with a big US broker.  They assume their account is actually sitting there.

Your account is only safe when it’s in a bank (or maybe an equity position) NOT when it’s sitting in a margin account.

Clients assume the broker uses the client funds in some sort of magic formula to leverage the money with their international banking connections.  They assume that somewhere through a network of high speed internet cables, fiber optics, WiFi, Iphones some voodoo and the miracles of modern finance,  when they click the mouse button to buy a standard lot of euro, they actually have access to $100,000 worth of Euros and when they close the trade for a healthy 100 pip gain that their account balance has gone from $30,000 to $31,000.  AND the important part is once the trader is flat, the money is safe – as good as cash – waiting around for the next trade or to be cashed out in exchange for a brand new 6 Series (minus all applicable wire transfer, financing and government fees associated with each appropriate transaction).

That’s right, when we trade through a US broker, we fail to recognize that there is still “Broker Risk”.  PFG clients as MF global clients before them failed to realize their entire account could be in jeopardy.  We live in the United States, we are protected.

No we’re not!  It’s our responsibility to protect ourselves. The government does not and can not protect us.

We can’t count on our government to protect us, or regulators to look after anything but their ego and time spent on C-Span or Bloomberg or CNBC when they defend the poor little client from some real or imagined crime.  Just think about it, when a broker is fined, the money doesn’t go to the alleged victims of the grievous act, it goes um…. to…… ummm…   Pay down the national debt, yeah, that’s it.  (want to buy a bridge?)

Remember, PFG just lost a $700,000 lawsuit for things they “should have known” regarding unproven  potential complacency in some ponzi scheme.  Now we find out, Mr. Wasendorf Sr. has embezzled somewhere around $200,000,000.00 over a 20 year period, and some government run acronym responsible for knowing things doesn’t know anything and isn’t responsible?  Yea, that makes sense.  Go ahead, try suing the NFA.  Let me know how that works out for you.  (Larry Williams – if you need to ask who he is, you’re just here for entertainment right? – has retained council for a potential lawsuit along these lines for his probable six figure loss.  Let’s allow him the grunt work on this one shall we?

So, how do we minimize broker risk?  How do we make sure our money is safe? How do we not lose our entire account to embezzlers?  How do we make our millions?  What’s the meaning of life and what are the secrets of the universe? Well, read my next blog post and I’ll talk about some of this.

Happy trading,
Kosentrade

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