Risk management must be based on realistic worst case scenarios. If we incorporate scenarios that are unrealisticaly extreme, we can just stop trading all together. For example, if we were to assume that it is possible for every component of the dow to go bankrupt overnight, I would then suggest never touching blue chip investments. ... but this is unrealistic. The reason why I am assuming we will not see an 800 pip gap on the major pairs is, first of all, we never have seen anywhere near such a gap, and second, the increasingly massive liquididty in FX makes an 800 pip gap scenario unrealistic.... even in extreme conditions following exceptional circomstances. Worrying about an 800 pip gap on major pairs is more paranoia than being cautious. The chances of you encountering counterparty default are far greater.
Technicaly, gaps are caused by a sudden lack of liquiduty. For example, if all of a sudden almost all the buy orders are retracted from existing levels, the next layer of buyers may be placed at much lower levels. In such a case, should anyone wish to sell (either existing long positions or fresh short positions, they will have no choice but to take the bid prices that have been suddenly lowered ... as soon as a trasaction is made at that lower level, that gap is caused. The key however to gaps is a sudden lack of liquidity. This is why I discount the scenario of a huge gap on major pairs ... the liquidity is just phenomenal on major pairs.
Thanks for the comments. How about the liquidity on most Monday mornings of Asia section in general? I'd think that should be fairly thin, comparatively. How about the rare possibility of extreme illiquid for one Monday morning in particular when all the major players trade the same direction?
The "massive liquidity" you speak of has a tendency to disappear completely during outlier events. Obviously we cannot trade paranoid, but the question is how you will react if such a situation develops. If you feel a market "can't" move X number of pips, you will likely not prepare for the eventuality -- by the time X is reached, you'll feel it's "too late" to get out, or double down, on your position, then suddenly we're down 2X etc . . . Alot of people have made the same assumptions on a variety of other markets -- and they have been crushed. Just hope you don't automatically trade on your assumptions and fade whatever move you deem "irrational".
It can happen very easily. For example, a nuclear detonation in Tokyo would make the yen drop like a rock - 10- 30%- because there would be no one taking a yen long position.
I dare say that there are hundreds of former traders/investors who are now selling used cars and facing a retirement on social security who had the same attitude. The reason why the failure rate is so high in any trading instrument is precisely because people don't consider worst-case-scenarios to be something that can actually...really...happen. Yes, you hear about the billion dollar blowups. But you don't hear about the thousands of individuals who blow up their net worth every year. I promise you that any trader who carries an attitude of "can't happen" is a trader who hasn't been mugged yet. And those who have been wacked, and are still around to talk about it, are much the wiser and wealthier because of it.
You are confusing "gap" and "drop" . If Tokyo blows up, yes, of course there will be a very brutal movement on JPY. However, despite such an event, I am confident that you could get out of a long jpy position (or into a short jpy position) without seeing a massive "gap"
I've been trading FX for about 13 years now, blew up 2 accounts in my first 2 years of trading and have been profitable and "conservative" for years now. I am not naive. That said, worrying about an 800 pip gap on the major pairs is about as useful as worrying about the end of the world .. if it happens it happens, what are you going to do about it? ... should we factor such a hypothetical scenario (that has never been seen) into our risk management ? If so, why not just factor in the possibility of the JPY (or any currency for that matter) being abolished overnight ? How will you factor in the possibility of a government abolishing its currency into your risk management ?
No one taking long JPY positions if Tokyo blows up ? ..maybe, but there will be plenty of JPY buying With all these small spec accounts scalping 20 to 100 pips, alot of short jpy positions would be overjoyed to close out their positions after even a 200 pip profit ... and when short jpy positions are being closed, this is done via BUYING jpy. .. liquidity is just way too huge in JPY to consider an 800 pip gap as a realistic fear. And again, if you do think it is a real possibility, just how are you going to integrate such a possibility into your risk management ? ... stop trading ?
For every trade I have open, I have a corresponding stop entered at the same time I open the trade .. always. Gaps in FX are far too small for me to worry about.