Trading a Real Market: What the Swiss National Bank Taught Retail Traders

http://mechanicalforex.com/2015/01/trading-a-real-market-what-the-swiss-national-bank-taught-retail-traders-today.html

by ca98am79 • 12 years ago

93 66 12 years ago

comrade13• 12 years ago

I don't think I understand how currency trading works. If you owned EUR the value of the EUR only changed relative to the CHF. If you owned CHF you gained 15% against all currencies.

How do people lose money on this? Are people somehow trading on the CHF/EUR exchange rate? And is so, why? The CHF was pegged to the EUR.

It reminds of when people were still trading shares in Genentech for years when Roche had an option to buy all GNE shares at a certain price, which they of course did eventually.

Is this another example of people trading without full knowledge?

sz4kerto2• 12 years ago

A typical, very trading strategy was used by many people (including the biggest absolute return fund in my home country) and robots as well:

- CHFEUR floor is 1.2 (or that's what everybody thought)

- so you short the CHF @ 1.2

- side effect: your money is essentially stored safely in a position that has no downside but has upside (or so you think)

- if, for any reason, CHFEUR is >1.2, then you exit your short position with some profit

- when CHFEUR is back to 1.2, then do the same again.

Works brilliantly, until the black swan flies through your window, and everything is full of shattered glass. So in short, people relied on the SNB's promise, they thought there's zero risk of this thing happening (i.e. removing the floor without notice), and took positions that had small upside with ~1 probability and huge downside with ~0 probability. At least they have a good story to tell now.

comrade13• 12 years ago

So you are trading on the exchange rate? What's happening in the background? I guess someone is writing these option contracts and backing them with real currency?

ghshephard2• 12 years ago

The issue is leverage. [1] [2] In order to trade $1mm worth of EUR vs CHF, you didn't actually have to have $1mm. So, if the CHF, for whatever reason, increased above the SNB peg of 1.2, you could then trade $1mm for, say, $10,000 in your account (100:1 leverage). Then, if there is a 1% move back to the Peg, you profit 0.01 x $1mm, or $1,000.

The reason brokers will give you this much leverage is that ForEx (up until a couple days ago) was one of the most liquid markets on the planet. If you hit a margin call, your broker could instantly liquidate your entire portfolio to cover any loss, with very little risk.

And then, the SNB walked away from their Peg, and the earth collapsed underneath all these traders (and brokers in some case) - All these traders/brokers who thought that a position could be liquidated at minimal loss, ran into a market with a scarcity (absence) of buyers, and were wiped for the entire value of their accounts (and more - lots of traders ended up with a negative position)

This is a wakeup call that people will remember or a very, very long time (and should have been learnt in the 2008 Mortgage collapse) - the potential for a black swan event is everywhere.

[1] http://www.investopedia.com/ask/answers/06/forexleverage.asp [2] http://www.investopedia.com/articles/forex/08/margin-leverag...

jayess• 12 years ago

A 1% move would net you $10k, not $1k. That's why it's so alluring. You can gain (or lose) a lot when you're leveraged at 100:1 (as most retail FX brokers allow) and the currencies move just a small amount.

gwern• 12 years ago

I don't think this is a 'black swan' event. The strategy was pretty explicitly premised on a binary event: the Swiss bank keeping the peg or not. It didn't. As OP indicates, the possibility of the peg breaking was understood by anyone who actually understood the trades they were making. And it's not like central banks have never failed to keep a peg in the past...

adam419• 12 years ago

Because a lot of people including institutions like Goldman Sachs and the FX brokers were short-selling the CHF (selling borrowed CHF on the open market hoping to pay it back at a lower price denominated in another currency). Except the trade went against them because it was worth more denominated in other currencies. What I don't know myself though is how they were expecting it fall if it was pegged. Perhaps they announcement coming but thought it would fall in price instead of rise.

kryptiskt2• 12 years ago

I don't think I understand how currency trading works. If you owned EUR the value of the EUR only changed relative to the CHF. If you owned CHF you gained 15% against all currencies.
How do people lose money on this? Are people somehow trading on the CHF/EUR exchange rate? And is so, why? The CHF was pegged to the EUR.

When you currency trade you go long one side of a currency pair and short the other. So you borrow 40000 Euro and buy Franc or vice versa. There is always a specific currency pair involved.

The usual reasons to take a position in a pegged currency is either to bet that the peg breaks (which people being long Euro obviously didn't do), or to extract value from a difference in interest rates (the carry trade, I don't know if that applied but there must have been something attractive about shorting CHF....)

comrade13• 12 years ago

Thanks. That makes sense to me.

vegabook3• 12 years ago

In FX you are always trading one thing against another. There is a long position, and a short position. In this case, you were long EUR and short CHF. When CHF revalued 15%, you had to pay many more euros to buy back your short. So if you started with 100 EUR long, 120 CHF short, at the pre-break exchange rate of 1.2, then when it "cracked" to say 1.05, you had to pay 120/1.05 to repay your short. That's 114.2857 EUR you had to pay back, but you only had 100 EUR to start out. Thus you lost 14+%.

By the way, poorly explained in the main post: most of the stops actually happened way below 1.05. The cross panic-traded down to 0.85 in the hour after the reval announcement, which is where most of the stops were occurring.

1.2/0.85 - 1 = a 41% loss.

Imagine if you were leveraged 100x......

malka• 12 years ago

Alpari offered leverage up to 500x. Craziness.

gnaritas• 12 years ago

I don't think I understand how currency trading works.

You're right, you don't, and it's too big a topic to explain in a comment, but basically yes people trade the exchange rates because they can and because if you do it right it's very profitable. You don't ever own either, currency trading is pairs trading where you're long one and short the other to open a position and exiting a position exits both trades which looks like a single trade to you.

George Soros once made a billion dollars shorting the GBP and forced a country to remove a floor, similar to what just happened here.

The EUR/USD has been sinking like a rock for most of the year, so traders short it, wait for it to sink more, and cash in their profits. It's just like trading stocks except you have more liquidity, more leverage, and going long/short are basically the same because these aren't stocks and going short the EUR/USD is identical to going long USD/EUR.

matwood2• 12 years ago

As others already mentioned, you always trade currencies in pairs. By breaking the peg anyone on the wrong side of the pair lost. Since currencies move very little, most currency trades are highly leveraged. A 20% move in a day basically wiped out entire fortunes.

The other people who are exposed are those who took out swiss franc mortgages from other countries[1]. I'm amazed this was even allowed, but up until now the franc was stable and the rates low so it made some sense.

[1] http://www.economist.com/news/europe/21639760-poles-were-slo...

nandemo• 12 years ago

It reminds of when people were still trading shares in Genentech for years when Roche had an option to buy all GNE shares at a certain price, which they of course did eventually.

Why do you think people would stop trading Genentech shares?

vegabook3• 12 years ago

What the SNB really taught people this week is what emerging markets people have known for decades, and actually, developed markets traders really should know too. You should never trade a peg in the direction that is being defended by a central bank. You should almost always fight the central bank.

Anybody who takes a cursory glance at history will know this: ERM 1992, Russia 1998, Brazil 2001, and yes, Russia H2 2014 (semi peg). The examples of peg breaks are numerous, and some recent. No excuses.

A "grid trading" strategy that was essentially recommending picking up pennies in front of a steamroller, was irresponsible at best. One should always look at the balance of payments of a country to see if it is in surplus or deficit, and trade the currency accordingly. Swiss was in massive surplus on the capital account. This guy was recommending selling swiss francs for a tiny, marginal carry trade in euros.

And if you don't know what balance of payments means, you really should figure it out before committing money to the FX market.

Finally, all the bull about liquidity. Of course there is no liquidity when a market revalues suddenly. This is the same in equities: if an unexpected announcement happens, the price revalues instantly and there is no liquidity in between. It is a discrete event. Econ 101.

thrownaway2424• 12 years ago

Complete agreement. If the central bank is defending a rate, "defending" means spending money, and you want to be on the side that's getting the money. Simple. Russia has/had been pouring money into propping up the ruble, said money was received by FX traders with the correct positions. The worst outcome for central banks, which is frequently what comes to pass, is they spend a ludicrous amount of money defending their position and in the end they still lose.

_delirium• 12 years ago

Is there good data on how often they lose? Sure, I can think of plenty of examples of central banks being forced to give up their peg, but I can also think of plenty of examples where the traders betting against them lost out. You'd need to consider both if you really want to use historical data as a justification for trading. For example the EUR/DKK peg has been challenged on numerous occasions without success. China has also been fairly successful in dictating its exchange rates, with some currency movements but generally on its own timetable and very carefully controlled.

gus_massa• 12 years ago

[Hi from Argentina!]

I agree, but usually the pegs in the other direction are more dangerous.

When the government has too many Dollars (or Euros) they usually have time to find a soft solution and change the conversion rate slowly. It's always easy to burn money.

When the government has too few Dollar (or Euros) the amount of reserved money go down, they exchange the real money for valueless internal bonds, and one day they get up and they don't have any money left in the treasure and they are forced to make an abrupt correction.

So this suddenly change is strange. YMMV.

vegabook3• 12 years ago

Good point, and China has for years adopted this approach. Problem is, they are now long of a trillion dollars of US debt, and are as a result, at the mercy of their own debtor. I think the Swiss were wary of that scenario: becoming longer of European debt. If they had adopted a gradual approach, they would have been showing their spoof poker hand, days after having asserted that the peg wouldn't move. The market would have sold billions more euros to them which they didn't want.

marcusgarvey• 12 years ago

It was bad form for the SNB to say they were committed to the peg and then to scrap it a few days later. On the other hand it shows how entitled markets have become to having central banks telegraph their strategy to the world. Would monetary policy & markets ultimately work better if we didn't expect central banks to be so blatant about their future moves? At the very least it would shake out the dangerous complacency that leads to overcrowded trades & heightened contagion risk.

paganel• 12 years ago

It was bad form for the SNB to say they were committed to the peg and then to scrap it a few days later.

I may be wrong, but I think the decision to get rid of the cap was ultimately the result of an ECJ's judge statement made the previous day: http://www.telegraph.co.uk/finance/economics/11344253/ECJ-ru... , so not much that SNB could do about it.

conistonwater6• 12 years ago

But that decision was about ECB's QE, I don't think this is as clear as you make it sound. SNB could have chosen to continue the peg through any ECB actions, but instead they chose to scrap it. It was still their decision, although you can argue that they wouldn't have been successful had they decided to continue the peg.

brianbreslin• 12 years ago

So this is slightly deviating from topic, but still on it. Can someone explain why forex has looked like shady stuff for so long and there are so many get rich trading forex ads all over the web? I have never dug into this, so I am just genuinely curious. How does that industry work?

jim_greco• 12 years ago

Lack of regulation. You can go to jail for advertising equities, futures, bonds, etc. like these bucket shops do.

t0• 12 years ago

When you have 50x or 100x leverage, you will either get rich quick or go to zero quick.

Scoundreller• 12 years ago

so many get rich trading forex ads all over the web Anecdotally, as a publisher, the CPCs (cost-per-click) are quite high, likely to make up for low clickthrough rates.

In other words, it doesn't seem like many people are interested in it, but the forex shops must be making fairly good money when they get a new customer.

tl;dr it's high-margin and low volume in terms of actual customer counts.

justincormack• 12 years ago

Pull people in, lose all their money via high leverage (stop them out when they lose), repeat with new sucker. You have to get new customers to pillage constantly, hence the advertising. Plus it is more or less unregulated (leverage is limited to 50x in US, unregulated elsewhere). The companies dont have to hedge the positions much, as many net out, and people will mainly be losing money.

tim3332• 12 years ago

Forex trading in itself is a fairly neutral, close to zero sum process. The people running forex adds get rich by charging commission on trades and selling get rich courses. Most small speculators lose their money. I guess it remains popular because it's not a total losers game - well informed speculators like Soros can make a great deal of money at it.

matwood2• 12 years ago

There is almost no regulation (insider trading is fine for example). Leverage is huge so it draws in the get rich quick people. FX has dealers instead of brokers, and I'm told from friends who have dabbled in FX trading, feels like a conflict of interest.

http://www.investopedia.com/articles/forex/06/sevenfxfaqs.as...

minimax3• 12 years ago

There is a good section about currency bands in Nassim Taleb's first book, Dynamic Hedging. It's a fairly technical book about risk management for options traders, but the section on Market Barriers is particularly germane.

I think it's valuable in the sense that it gives you a window into the way a skilled risk manager views the world versus the naïveté of retail traders. This was only a "black swan" event if you had no idea what you were doing.

https://books.google.com/books?id=-5-OldaTjVQC&lpg=PA227&ots...

onewaystreet• 12 years ago

His advice is all well and good but "skilled risk managers" can be just as dumb as everyone else. This has been proved multiple times in just the last few decades alone.

300bps2• 12 years ago

His advice is all well and good but "skilled risk managers" can be just as dumb as everyone else.

I work at an investment bank and I can safely confirm that most professional investment managers and risk managers fall for this type of stuff all the time.

If you want an example, look as Nassim Taleb's idiotic moves. Here's just one from 2010:

http://www.moneynews.com/StreetTalk/Nassim-Taleb-Shorting-Tr...

So in 2010 Taleb's advice to short U.S. Treasurys. How'd he do in the last 5 years? If he followed his own advice then he lost almost half his money on that trade as US Treasury rates fell dramatically since then.

I'm not picking on Nassim Taleb. He's a smart dude. But everybody - everybody - makes dumb investment decisions.

PhantomGremlin3• 12 years ago

Not everyone was surprised by the SNB's action. I haven't seen the following discussion reported widely. I only have a link to a video, no transcript. But it's short, little over 1 min in length.

Some smart money started moving into CHF last month. More interestingly, there was a lot of movement about one minute ahead of the announcement.

http://finance.yahoo.com/video/traders-knew-snb-move-pro-060...

Here's the ending:

   Announcer: despite everything we've heard about
   manipulation of foreign exchange markets, about
   the deep forensic look into these markets,
   you're saying there was action before the
   announcement which indicates there was some
   parties in the market that knew this. I want to
   be categorical about this.

   Guest: It definitely looks like that to us.
   There was a movement in the market well ahead
   of the headlines, and a huge flow throughout
   December, an unprecedented flow, in the leadup
   to yesterday's break of the peg.

squozzer• 12 years ago

Not a trader certainly not forex but the blood was in the water the day the Swiss decided to peg. Certainly they had their reasons - to keep the franc from becoming too strong - but as other commenters have already explained pegs are too difficult to defend and in this case, the EU was nowhere near a consensus on monetary policy. I like the "picking up pennies in front of a steamroller" analogy it fits the situation perfectly.

AnInternetGuy• 12 years ago

And that is why you make high-risk trades with options, or not at all.

Trading a Real Market: What the Swiss National Bank Taught Retail Traders

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