Your futures, forex, CFD or commodities trading accounts can be destroyed when your broker goes bankrupt. Broker collapse can ruin your financial affairs. When a broker goes bankrupt, all client accounts are frozen. What would happen to your trading positions if your broker freezes your trading account? How would you fare if your broker closed your positions at terrible prices, against your will?
Successful trading requires that you always contain your worst case potential losses within rigid immovable limits. You need to control the potential loss of your whole account more so than you need to control each trade. You need to protect your account against your broker going broke.
If your broker goes bankrupt you will suffer loss, disruption, grief and possibly emotional turmoil which will persist for months, until you get some of your money back. If you hold a cash deposit account with your broker it will be frozen, you will be denied access to your funds, and you will be unable to withdraw your money. If you do not own your trading instruments outright you will lose control of your trading positions, and:
- you will be prevented from adjusting, closing or otherwise managing your positions;
- your positions will be closed at terrible prices, further destroying the value of your account;
- you will almost certainly lose money; and
- you might suffer prolonged emotional distress.
Segregated accounts are usually not completely segregated. They can accumulate losses across all clients’ accounts reducing the fraction of your funds returned to you, even if your trades did not incur any losses. It will take months if not years to sort out, and after being sorted out, you will likely lose.
Some brokers will even make a margin call of you while they are about to freeze you out of your account.
Risk control is critical to successful trading. If you strictly control your worst case potential loss on every trade, and of your whole account, your trading performance will be better than if you don’t. If you are properly insulated against your broker’s failure:
- the complete amount of cash in your cash account will be preserved;
- your cash will remain available to you at all times;
- your trades and positions will remain under your complete control at all times; and
- you will have less risk to worry about.
If you take simple measures to protect your trading accounts, you will be free to concentrate on the real business of trading and investing. You will be rid of emotional distraction. Your trading performance will be better. There are a number of things you should do.
Minimise counterparty risk
When you open a CFD position, your position is only as good as the creditworthiness of the CFD provider. You are exposed to the risk that the other party to your contract, usually your broker, will fail. You should eliminate that counterparty risk.
Don’t put your money into segregated accounts
Segregated accounts often can never be completely segregated. Avoid using segregated accounts to the fullest extent possible. In theory, a segregated account is supposed to keep client moneys separately from the broker’s finances. But under most regulatory regimes brokers are permitted to use funds in segregated accounts to hedge collectively for all clients. That means that individual clients’ segregated funds can be pooled to engage in collective hedging. Your money can be used to hedge another client’s crazy position. If the broker collapses with hedging positions open, those segregated funds used for hedging will be at risk, or gone. In winding down all clients’ positions and broker hedging, and in restructuring the broker’s business, it is likely that money will be lost from those segregated accounts. Not all of your money will be there. Perturbed broker administration, new broker management and the chaos of collapse, can allow the hedging to be mismanaged, amplifying losses from segregated accounts.
Keep your cash in a separate bank from your broker
You should keep your trading account cash in a bank which is completely separate from your broker. Choose banks which are completely unrelated to your broker. If you hold your trading funds in an account with a separate banking entity your funds will remain available, immune from any broker failure. Don’t deposit cash into, or allow cash to be held under, broker management, if possible. Only use brokers which can link your trading account to an external bank account. Choose a broker who makes individual withdrawals from, and deposits into, your separate bank account for each trade, as needed. And your idle cash will earn interest: broker accounts often don’t pay interest.
If you must use a broker who requires you to deposit your cash into their account, keep the amount to the absolute minimum at all times.
Don’t use over the counter derivatives
To trade CFDs you enter into a contract with the CFD provider, who is usually also your broker. CFD contracts are usually not transferable, so you are locked into that provider. CFDs are “over the counter” (OTC) derivatives, which means they can only be managed “over the counter” of your CFD provider. Your CFD provider is your counterparty. If that counterparty fails, you can not transfer your position to another provider or broker. To reduce counterparty risk: don’t use OTC derivatives. Instead, use publicly listed exchange traded instruments which are traded through a clearing house.
Ensure you own your financial instruments outright
You never own any underlying asset with a CFD: it is a simply contract with the provider. In contrast, if you buy publicly listed stock or exchange traded options (ETO) contracts, you will continue to own those instruments after your broker goes broke. When you open an options position the clearing house becomes the counterparty. Stock and ETOs are held in your name. The rights are transferable, and they can be traded through an exchange. If your broker goes broke, you continue to own, trade, manage, adjust and close stock and ETO positions through other brokers who are not broke. That means you are no longer dependent upon the writer or your broker for the performance of your financial instrument.
By trading instruments which can be owned outright, no broker or other party can interfere with management of your trades. Clearing houses usually have much lower counterparty risk than CFD providers or individual brokers. If ETOs are unavailable then it is better to trade the underlying asset directly, if it can be owned.
Strictly control the worst case possible loss on every trade
Always use rigid stop losses to strictly limit your worst case potential loss. Stock and commodity prices, and forex rates, can gap wildly through stop loss limits. On occasions you can lose more than you plan to lose if you trade stocks, forex, futures or CFDs. If you trade CFDs you must use guaranteed stop losses.
Exchange traded options allow you to strictly control and limit the worst case possible loss on every trade, at all times throughout the trade. You set the limit in advance before opening any position.
Exchange traded options provide upside leverage, and allow you to strictly control risk at all times. You should only use basic options strategies which strictly limit your worst case possible loss at all times. Using plain bought options or basic spreads, you can never lose more than your initial outlay, no matter how disastrously your underlying forex rate, stock or commodity moves in the wrong direction.
The pay-off diagram of a plain bought call option position for a bullish trade over MacDonalds stock, currently trading at around ninety-six dollars, is shown below. The vertical axis shows potential profit and loss. The horizontal axis represents the stock price. The horizontal line showing a loss of $405 illustrates that the absolute worst case potential loss is strictly limited, throughout the whole trade, and no matter how far the stock price might fall the wrong way. The line rising to the right shows how options amplify profits should the stock rise.
[Courtesy OptionVue Systems]The worst case possible loss of a call option bullish trade is absolutely limited
[Courtesy OptionVue Systems]
The worst case possible loss of a put option bear trade is absolutely limited
Never use margin. Never expose yourself to the possibility of a margin call. If you are exposed to margin calls you can never rigidly control or limit your losses. Use options over futures instead of directly trading futures.
Have accounts with at least two brokers
It takes time to open a broker account. Trade through at least two brokers. If one goes broke you can continue trading your stock and options positions through the other.
Shift your attitude
The approaches outlined above will require a shift in approach for some traders. That can be difficult. I have shifted myself to this approach because of various experiences over the years.
It is a good idea to ask your broker what would happen to your money if the broker went broke. Also, very carefully examine their terms and conditions. It is better to ask your broker before opening your account, while the broker is still keen to attract your patronage.
Wherever possible, I do not use segregated accounts. I strongly prefer brokers who don’t want me to deposit any of my money into their account. I retain my funds in a bank account separate from my broker, and I give my broker deposit and withdrawal rights for each trade.
When I can not avoid a segregated account, I maintain the absolute minimum cash balance, sufficient only to cover my expected near term trading. I transfer surplus cash into my bank accounts at the earliest opportunity.
I never use CFDs, direct futures, or margin. I am never exposed to any margin call.
I always use exchange traded options if they are available. Options almost completely eliminate counterparty risk. Options allow me to set a strict upper limit upon, and to control absolutely, the worst case potential loss on every trade. No matter how seriously a trade goes wrong, my loss can not exceed the limit I define in advance. Where options are unavailable I trade the underlying asset if I will continue to own the asset should my broker go broke.
I sleep very well at night, and emotions don’t distract me from disciplined trading.