How to lose £50,000 on a £1 bet
John C Burford explains why a central banker's guarantee is usually a signal to foreign-exchange traders to do the opposite.
Today, I want to show you what happens to traders when they follow the crowd.
They get killed!
You'll have probably heard about the Swiss franc in the last few days. The whole world is talking about it.
What happened? Well, last week the Swiss Central Bank abruptly abandoned its currency peg against the euro.
(In a currency peg, a central bank promises to buy or sell its own currency to keep its value fixed against another currency. So it 'pegs' the value of its own currency to that of another.)
The Swiss central bank had promised to keep the Swiss franc pegged at €1.20. But in the middle of the night on Thursday it broke its promise.
Easy money
This was a dream for speculators. So long as the euro was falling, and the peg stayed in place, they could bet that the Swiss franc would fall against other currencies. Easy money.
Just days before, the head of the bank emphatically stated the peg was 100% safe. He said that there was zero chance the Swiss franc would be allowed to appreciate.
But just a moment's thought would have convinced anyone that, with the euro in freefall in recent months, this was a very expensive policy for the central bank to maintain (the more the euro fell, the more the Swiss central bank had to pay the speculators to keep the peg intact). And central banks are not in the business of losing money.
So why is this happening now? Well, on Thursday everyone expects the European Central Bank (ECB) to announce its first quantitative easing (QE) programme. It's going to flood the market with hundreds of billions of euros, which will drag down the value of the euro.
Keeping the Swiss franc pegged to the euro, while the ECB does QE, would cost the Swiss central bank a lot of money.
How traders got fleeced
Look at the number in the red box. It shows that among speculators, there were five times as many bears selling as there were bulls buying. That's about as lop-sided a state of affairs as you will encounter in a widely-traded futures market.
Commitment of traders data for the Swiss franc last week
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| Non-commercial | Commercial | Total | Non-reportable positions | |||||
|---|---|---|---|---|---|---|---|---|
| long | short | spreads | long | short | long | short | long | short |
| CONTRACTS OF CHF 125,000 | Open interest: 66,272 | |||||||
| Commitments | ||||||||
| 4,922 | 31,366 | 661 | 54,425 | 8,634 | 60,008 | 40,661 | 6,264 | 25,611 |
| Changes from 06/01/15 (Change in open interest: 1,845) | ||||||||
| -625 | 1,648 | 190 | 2,782 | -702 | 2,347 | 1,136 | -502 | 709 |
| Percent of open interest for each category of traders | ||||||||
| 7.4. | 47.3 | 1.0 | 82.1 | 13.0 | 90.5 | 61.4 | 9.5 | 38.6 |
| Number of traders in each category (Total traders: 47) | ||||||||
| 7 | 22 | 4 | 9 | 11 | 19 | 34 | ||
So what happened next?
The chart says it all:
US dollar/Swiss franc, one-minute chart
This is the one-minute chart of the US dollar/Swiss franc, which reacted similarly to the euro/Swiss franc. When the bombshell hit in the dead of night, the market crashed by 50% in minutes as speculators all rushed to sell at the same time. The crowd was in panic mode!
If you had been betting against the Swiss franc on a spread betting platform, you'd have suffered catastrophic losses. At a bet of £1 per pip (the tiny unit you are betting on), a drop from $1 to $0.50 on US dollar/Swiss franc would have represented a loss of £50,000.
By the time most of us had woken up on Friday morning, the market had stabilised.
But even at that level, the potential gain was around 1,500 pips overnight for those who bet against the crowd. They would have made you £15,000.
What have we learned?
First: never trade with the crowd especially after a consensus has hardened around a market trend.
Second: never believe a central banker, especially when they make a cast-iron guarantee as the Swiss did in 2011 when they committed to pegging the value of the Swiss franc to the euro.
I have a feeling we shall see more central bankers' promises broken this year.