Last week the National Bank of Switzerland (SNB) announced that it will remove its peg to the Euro currency. As a result of this decision, the Swiss Franc currency soared 30%, and wiped out many retail traders, brokerages, and even sophisticated traders from various hedge funds. The focus of bloggers, journalists, and many news outlets has quickly turned to the impact of the SNB’s decision on many institutions who have relevance to the Swiss Franc, but little emphasis has been placed on the topic of leverage or the concentration of positions which has been one of the primary causes of trading losses during this unprecedented news event.
“Black Swan” events or “Fat Tails” are nearly impossible to predict with any financial model, therefore being being strict on leverage and risk limits is essential not only in specific cases such as these, but for all trades.
First, let’s discuss the significant elements that took place during these market movements:
1) SNB came to the decision to remove the rate-restriction peg to the Euro. This delivered a blow to many institutions in the financial industry due to the policy change in the interest of their country, and not in the interests of the financial community as a whole. The ‘Don’t fight the fed’ policy that many have believed in has proven to be unreliable. Sadly, the group of academics that control central banks are able to make announcements with little consideration for the trading community, and the effects of the trading community and financial institutions that result from these announcements.
2) The market soared 30% within hours. Only time will tell whether this was an overreaction to the announcement, but the end result meant liquidity providers had to scramble to accommodate the influx of orders. The markets can accommodate good news, they can accommodate bad news, but they can have an affinity to issues where there is difficulty interpreting the long term implications of breaking news. In this case, the Swiss Franc (CHF) exchange rate policy change will alter the economy, exports, Swiss currency borrowers, and more. With this in mind, it does not seem that the policy change should have been implemented overnight, but who is to say that economists are the best at what they do? Switzerland has the lowest debt-to-GDP ratio of 33% while the USA has 71.8% and Japan has a whopping 226.1%. (Party in Tokyo, anyone? Anyone?)
For those that are looking for rationale and logic within this market move, good luck. Identifying the precise reason a market has moved in such a dramatic way can lead to unsubstantiated theories that rarely provide any further assistance to a trader. Let’s discuss in detail what happens during these moves:
Within seconds of this announcement prices started to gap while liquidity for those who are on the opposite side of the tracks has dried up and caused execution to become nearly impossible. On some broker’s desks, the gap between the bid & ask has inflated up to 2,000 pips. In these cases, even for a trader on the ‘right’ side of the track, a Market Order could have provided far less of a gain than expected due to dwindling liquidity. Yes, even in a situation where a trader is right they must be able to execute at the ideal price for exit for it to be worth it. Black Swan events, like the Flash Crash, tend to create a large bid-ask spread that prohibits traders from executing within their normal price differential. For example, during the Flash Crash, the Emini S&P bid-ask was 12 points, or 48 ticks wide.
Every single point above can affect a trader, even if they are not in the market at the time. Why is this? This is because it is possible within any asset class, where it be stock indices, energies, metals, or others. The psychological effect of seeing it in real-time can jar a trader.
Many traders will go and compare this to a Black Swan event. However, in reality, it is not. We live in a world of countless intertwined and interconnected economic policies, politics, and ever changing supply and demand that constantly shifts the markets. Central banks, policy makers, and those who determine actionable events that can affect pricing do so in the interest of economics and not to satisfy speculators or market analysts. Unfortunately, as demonstrated by the SNB, the implications of such policy changes can be further reaching and with more drastic changes than they may have anticipated.
The longer a trader has been in the game, the more likely they will have encountered these rare, but significant events that many will call a Black Swan. Events such as these can come by surprise, which is out of the control of the trader. However, leverage and risk management can provide major impact on the bottom line. The key is to constantly, and strictly, control risk for all trades. Risk, risk, risk: It should be a habit, and the first thought that comes to mind when looking for trade setups. The institutions that were most affected, and went under as a result of the SNB policy change, were either heavily concentrated in the Swiss Franc, and/or extended leverage to customers beyond what many would consider sound risk management. Even though one may have concrete risk measures put in place they must also keep in mind that the maximum leverage extended may not the best use for every trade. Consider if a fund leveraged 1:20. In this case, a 5% move could wipe out 100% of the fund’s equity. As we all have heard before: Leverage is a double-edged sword.
It is also valuable to be wary of what the consensus is amongst traders. The financial media can only provide accurate commentary and explain what the current state of the market calls for, but trading in line with the media can be a recipe for leaning towards the wrong side of the market. It is important to study and develop a methodology that is individualistic and specific to one’s trading profile, risk concerns, and strengths rather than to lean too far on a single resource for information.
Of course, the thought may come to mind: “Well, there must have been a winner here somewhere.” Even though many were affected negatively, the game of zero sum does not necessarily apply here. Those who did hold long CHF positions, or long 6S Futures, were very far and few between. The winners will hopefully emerge, but the proportion in size to the effect on losers is not always equal. The fundamental dynamic for a rate limited currency would not allow for any rational trader to take the other side of a strict policy. Therefore, going long the CHF was not only risky, but just not practical for most. To the credit of some market commentators, they did question the rationality of pegging the CHF to the Euro and argued that it would eventually need to be removed. However, speculating on such an impactful policy change, and actually entering into a position are not comparable in risk. An article that theorizes such a scenario doesn’t need a stop-loss.
In summary, it is essential to constantly evaluate, monitor, and double-check the amount of leverage that is deployed for each position. Leverage can be beneficial in many ways, but it must be used carefully and with complete awareness. It is recommended to have a clear, defined risk model that incorporates leverage in a safe way to combat any single event from wiping out an account. Ambiguity has no place in risk, or leverage, and should not be decided based on intuition, but with caution and hard numbers.
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