Sunday, June 14, 2020

Risk management lessons from negative oil price fiasco in Apr 2020

When people who care about me know I invest/trade in financial markets, the natural question they will ask next is whether I can make good money from the markets. I tell them I am not sure if I can make good money but I am at least confident I won't lose big money. I feel more confident in my risk management than money-making ability because risk management is a more controllable process.

The 20Apr2020 negative oil price fiasco has shaken my confidence in my risk management even though I was not personally affected by it. I do not touch oil futures or whatever stuff which I am not confident of having an edge. I am lucky to have lost enough in the past to learn that lesson.

 I have 3 basic rules for risk management;
  • diversification
  • keep each position size small
  • cut losses quick (for trading positions) 
These rules failed to protect a person from blowing up his account even if he is conservative and is disciplined with taking risks had he bought oil on 20Apr2020.

On that fateful day 20Apr2020, May WTI oil futures fluctuated between USD18 and -USD40, settling at -USD37.63. Suppose a retail trader bought at $0.50 that day and the notional value of his oil position amounted to only a small 3% of his portfolio. If oil had dropped to zero and stopped there, he would have lost 3% of his portfolio at most. However, oil settled at -USD37.63 and that would result in a loss of 225.78% of his portfolio value just from that single small 3% position alone.

This should not be so disastrous if the trader had been able to cut his losses quick. Unfortunately, several retail traders were not able to because their broker's software was confused by negative price and could not take in new orders to cut off the losing position. This happened to customers of Interactive Brokers (IBKR).
At midnight, Shah got the devastating news: he owed Interactive Brokers $9 million. He’d started the day with $77,000 in his account.
Fortunately, IBKR will compensate the losses incurred by customers who were locked in with a long position during the time the price was negative.

I have always thought my risk management rules will keep me safe as long as I remain disciplined but this false sense of safety could have led me and my family to disaster if I had taken even a small oil position that day.

Here are some lessons I draw from this black-swan event;

  • Avoid open-ended risks as much as possible. 
    Open-ended risks mean losses can go beyond 100% of principal. Oil futures has the possibility of negative price, so even going long has become an open-ended risk. Furthermore, futures have built-in leverage.
  • Use futures for hedging, not speculation unless one has an edge.
    Futures were invented for hedging purposes, not speculation. Retail traders really have no business trading in oil unless they have an edge.
    If experienced oil traders like Hin Leong have blown up, what chance do retail investors have of success?

    A wise investor advised not to trade in commodities unless one is a user of the products. Oil futures are more relevant for genuine users of oil like refiners who need to hedge the cost of crude oil. 
  • Invest/trade/speculate only when one is confident of having an edge
    If I did not follow this rule and made an oil trade on that fateful day
    20Apr2020, I would have suffered many sleepless nights until the day IBKR announced they will make their customers whole for the losses incurred for negative price.
  • Stick to financially strong brokers
    IBKR agreed to make good the clients' losses since it was IBKR platform's fault for not letting clients cut their losses when prices went negative. IBKR can easily afford to make the compensation because it is financially strong. It takes money to be ethical and do the right thing for the long-term good of the business. 
    I have been a happy customer of IBKR for several years and am one of the admins for a Telegram group set up by voluntary IBKR customers to support Singaporean IBKR customers. Having said that, it is not safe to put too much of your eggs into one basket. It is safer to use a few brokers for diversification even if it results in higher cost.

Picking the right Valentine. A much more difficult task than picking the right stocks

9 years ago, I wrote about choosing your Valentine from a value investing standpoint. What I wrote then still stands today, Beauty is over...