FX Trading and the Big Bad Swiss Franc: Three Lessons You’d be Foolish to Ignore

 

We received some interesting comments on our post about FX trading and spread betting.

One of the most heartfelt was the

‘Don’t do it!’

by our friend Sara from the Debt Camel. (We love her site and if you need no-nonsense information about debt busting go, have a look!)

Sara raised a very interesting issue that highlighted some of the reasons to beware of spread betting and FX trading. She mentioned a Telegraph article about the people who had lost a lot of money last January when the Swiss National Bank lifted the cap on the price to which the Swiss Franc could go.

This action hurt many people who had taken a position expecting the Swiss Franc to decrease – in fact, it increased by an enormous amount.

Today, we’d analyse what happened and because we believe that the most important thing is what we learn, we’ll also share three absolute rules of FX trading and spread betting.

(What is spread betting?  It’s a derivative form of trading that allows traders to speculate on the price movements of various assets and potentially profit from rising and falling markets without owning the underlying asset.)

(I still can’t resist mentioning that the people who bet that the euro will increase against the Swiss Franc were betting on yellow were they playing roulette. So the ground zero rule is to learn ‘the rules of the game’ and learn them well.)

A little history…

The Swiss Franc (CHF in shorthand) is considered one of the safest currencies around. It has only been devalued once, in 1936 during the Great Depression, and has had spectacularly little inflation.

Switzerland was part of the Bretton-Woods system post World War 2 but like most currencies has been free-floating. The Swiss have a long history in finance – to the point of their banks being derided as the Gnomes of Zurich by Harold Wilson in 1967, which may seem a bit ironic given the UK’s more recent experience. But given the importance of Switzerland in the financial world, the CHF has remained an important currency and has been trusted by many people.

About 3 years ago, the Swiss National Bank (SNB) put a cap on the currency because the turmoil of the Euro had led to investors changing their Euros into Swiss Francs. The result was the value of the Franc soared which caused distress in Swiss businesses – as well as tourism, Switzerland is a major exporter of high-value manufactured goods.

The SNB cap – i.e. a floor on the Euro – was set at 1.2 Francs to the Euro below which it should not be allowed to go. The way this worked was that the SNB created a lot of Swiss Francs and used these to buy Euros. This effectively supported the Euro and stopped the Franc from soaring. To discourage holding of CHF further, the SNB also introduced negative interest rates.

The wisdom of these actions was questioned at the time but as a result, the SNB is now a major holder of Euros.

These moves did not stop pressure on the Franc so on 15th January 2015, and without any warning whatsoever, the SNB abandoned all efforts to limit the currency. The predictable result was that the CHF gained some 30% almost in an instant, although it fell back a little to about 20%, where it has stayed.

Because many people had ‘trusted’ the central bank and the volatility was very low beforehand because of the cap, people were expecting only small variations so some were short on the CHF (e.g. long in Euro and dollar). Some of these people pretty nearly lost their shirts over the affair.

While some traders were ‘retail’ investor (jargon for amateurs), quite a few were professionals working for big banks and the like but of course they would not own up to losing so much and the bank could take the hit without the bad publicity. The small investor however is much more vulnerable, not so shy and immediately cried foul.

The problem was badly compounded by some retail platforms that took a long time to close the positions – one in particular took over 30 minutes – so that the price went way past the sensible stop-loss set by the traders. All the people mentioned in Sara’s comment were on that particular platform which clearly has questions to answer. Legal action is currently being considered, but a few others actually went to the wall. Other platforms closed positions pretty quickly although even then, many of their traders did take a hit.

These all point to three absolute rules of FX trading

#1. Do not risk too much.

The wisdom of most traders is that 1% is probably too much, given the leverage offered. Some suggest levels as low as 0.25%.

In other words, trade in small amounts more often and you will be much safer. We are not talking about high frequency trading or scalping, both of which are really for the professionals only, but the sort of trading that can be carried out manually.

Some people regularly trade quite few per cent, which is OK if they get away with it but not if something like this happens. For while the events of January 15th will go down in history as a massive error of judgement by the SNB with some calling into question their competence, we only need a major disaster or some other event to cause a similar big swing and you can be badly affected.

You need a sufficiently large account to be able to make a profit on such small trades. Some platforms require a minimum stake of £1 per pip so with approximately 100 pips (i.e. £100) as a margin and taking a 1% risk, unless you have a £10,000 account, you should not trade at all.

Other platforms trade in lots that are much smaller – less than 10p – so a £1k account would suffice to get you started.

Remember that margin is not a guarantee or a stake in the conventional sense. Losses can be larger than the margin and can even lead your whole account to go negative, as happened. If your available margin falls below a certain amount, you will be warned when you open the position but that does not limit your potential losses.

It is not like horseracing or most other forms of gambling where the most you can lose is your stake. Stop-losses are also generally not guaranteed – there were no guaranteed stop-losses in the CHF at the time anyway – and their use should not be depended upon.

2) Beware of the platform that you use and watch the small print.

Apart from checking the margin requirements and minimum stake, keep an eye on ask-bid (buy-sell) spreads and any commission – which is generally each side (i.e. on both open and close positions). Make sure that the platform will hedge your positions – at least their net position – buy buying or selling real currency to protect themselves and you from sudden market movements but this shouldn’t give them an excuse not to close positions promptly.

The argument that the errant platform made was that there was not enough market volatility when the SNB removed the cap – that is they couldn’t find anyone to buy their net position. This is a pretty weak excuse – they could have closed their client positions first then closed their net position or taken the loss and waited for the market to return, which it did to some extent later on. Other platforms managed to close positions within a minute or less and/or forgave small traders who had amassed overall negative accounts.

3) Never, never, Never, NEVER go into a trade where there is political, or other, interference on either side of the currency pair! (Sorry for shouting.)

The dollar, euro, pound and yen are pretty safe – and liquid – among the majors, as was the CHF before the cap was imposed and presumably now.

But everyone knew about the SNB cap – if they didn’t it was pretty obvious from the charts as the volatility was particularly low.

What is worse, looking at the percentages from a typical source, the net long-short in EUR/CHF just prior to the announcement showed 92% of trades were long in EUR and only 8% short. The latter were probably quite pleased with themselves!

So don’t behave like lemmings – steer clear also from a number of currencies such as the rouble, the Argentinian peso, the Chinese yuan and others. In most cases these are quite minor currencies so the spreads will be large anyway (i.e. little prospect of a profit) but all the same, be very careful.

Finally…

There are people who make a living by trading. What happened with the Swiss Franc though is a salutary lesson for all.

If you want to trade, do it properly and follow good guidance and don’t ignore the three rules discussed in this article.

And whatever you do, please pretend to be Mr Spock when trading currencies. Letting emotion in is a recipe for disaster.

photo credit: Swiss Francs via photopin (license)