Forex Market Commentary
The Brexit trade is the most important trade of 2016.
For a trader to trade
successfully then prices must move in a direction rather than stand still. In
this world of trading there are the giants and then there are the small traders
who try to make a living by observing how the giants will fight and make prices
move. Through observation a small trader can learn a lot how the giants move
prices and how they react to the news media and fundamental economic data. This
year 2016 a large event is going to occur in the trading arena and this large
event is going to bring out all the giants into a full scale war. Whether the
small trader can learn form the past to anticipate how the giants will tussle
in the coming price action remains to be seen as the story of the Brexit begins
to unfold.
What
is the Brexit?
Brexit is an
abbreviation of the word "British
exit" that follows from a term coined in 2015 under a similar event where
the Greek people wished to vote on a withdrawal from the European Union; hence
the term: Grexit. The people of the United Kingdom will hold a referendum on 23
June 2016 to determine if the United Kingdom should remain or withdraw from the
European Union.
What
are the markets that are likely to be impacted?
The scale of impact of
the referendum decision will cover every single market across the globe from
currencies to equities, bonds and commodities. The magnitude of a withdrawal
cannot be understated. At stake is the very credibility of the European Union
and the withdrawal of the United Kingdom could definitely lead to the
unraveling of the financial and political system in Europe with far-reaching
financial implications around the world on a scale far larger than the seizures
caused by the collapse of Lehman Brothers in 2008. In the currency markets in
particular the major trading pairs GBP/ USD and EUR/USD will come under severe
stresses should the vote lead to a withdrawal.
On the 16 September 1992 “Black Wednesday” the British government was
forces to leave the precursor to the European currency, the ERM, as large
speculators like George Soros sold the Pound Sterling and drove it under it’s
trading limits to the Deutsche Mark. The British government was forced to raise
interest rates from 10 per cent to fifteen percent that afternoon to defend the
value of Pound sterling. Upon the announcement that the Uk had left the ERM
project the currency speculators stopped selling Pound Sterling and rates were
restored to 10 per cent. HRM Treasury lost the amount of £3.4 billion in a
single afternoon attempting to buy Pound Sterling on the open market. Should
the people of the United Kingdom vote to exit the European Union the crisis
that may unfold will definitely far more severe for both HRM treasury and the
ECB as large currency speculators may attack the two currencies to such an
extent that interest rates would have to be forced up to defense the Pound
Sterling and the Euro currency as traders sell the apirs in favor of the
stability of the US Dollar.
Who are the major
players in the forthcoming arena?
Giant hedge funds are
the largest players which move in silence in the currency markets by way of
derivatives contracts. Most commercial banks have shut down their proprietary
trading rooms. With the SNB meltdown that caught the currency markets by
surprise many large international banks were caught flat-footed and incurred
hundreds of millions of Dollars in losses through proprietary trading units
within the respective banks that traded for profit on their own bank books.
Large commercial banks today prefer to make fee income for their customers by
charging pips and percentages for booking spot and forward rate agreements
(FRA).
How will these giants
position themselves?
There is a deeply
troubling feature of the current markets at the moment through a pervasive
silence. When the markets are this quiet it is usually the forerunner to an
epic position to be built as in crude oil, bullion and Euro shorts in 2015. The
giants are not overtly piling into gold bullion and neither are they piling
into crude oil shorts. The US Treasury market is relatively quiet and the stock
markets a whole lot calmer than the fluster caused by the China break down last
summer. Giants always leave footprints and the astute trader must listen to the
sounds in the wind for a new direction. In the currency markets it is very clear
that the current silence is the forerunner of a large position that is going to
be built in the weeks ahead just prior to the Brexit crunch vote.
The giants now
have two options:
Option 1 – The giants
can position themselves for a massive drop of confidence in the GBP/ USD and
EUR/USD with a short position. Usually when markets break they drop like a
stone and as the ERM crisis of 1992 and the recent minor SNB crisis of 2015
demonstrates; markets can go into instant freefall with currencies dropping several
hundred pips in a matter of seconds.
Option 2 – The giants
can position themselves for a brief long on the GBP/ USD and EUR/USD with a
long position which may push each currency up a little before economic reality
of interest rate and economic cycles of the UK/ Euro zone and USA begin to set
back in and the USD begins a quiet appreciation.
Thus concluding: Option
1 – gives a massive potential strategy that encompasses a sudden and massive USD
appreciation compared to Option 2 – which may give us a USD retracement after
the Euro zone euphoria, pause and then gradual appreciation towards the end of
2016.
Giants in the currency
markets will position themselves firstly by way of OTC options. The currency
markets are largely OTC in nature. The interbank spot market represents but a
fraction of the currency trading world which is largely forward rate agreement
from a week ahead to 1 whole year forward. A giant wanting to take a step along
route Option1 will accumulate OTC put options 10 million USD in face value in the
pair GBP/ USD and EUR/USD fully knowing that come election day they could let
the options phase out worthless and take instant massive long positions within
the Interbank spot market should the vote keep the UK within the EU. Giants can also lock FRA – Forward rate
agreements to sell the in the pair GBP/ USD and EUR/USD in blocks of 10 million
USD. Should the giant wish to hedge Option 1, they may think of taking a
straddle combination of put and call options at a strike price best suited to
the value projected for the referendum day. Option 2 – may see giants taking
long call option positions in OTC blocks of 10 million USD and should the
euphoria of the “stay” vote run out of steam in the aftermath a quick profit
would be realized before the resumption of shorts on the pairs due to economic
reality of diverging forward yield curves between the USD and GBP and EUR.
As
a small trader how can I position myself?
Bearing in mind the
troubles we saw with the Jan 2015 SNB movement one would be wise to use FX
platforms that have deep liquidity to sustain casualties of sudden 500 pip
moves against the wind. My overall preference is to sit out the FX platforms
around the period of the UK vote and to trade the aftermath. If a small trader
wishes to take a position then I would examine other trading avenues like to
switch to exchange traded futures and options contracts. There are many large
FCMs that can accommodate the small trader like ADM Investor Services and RJO’ Brien as well as banks like Credit Susse and JP Morgan in a list of trading
houses that have been round the block and sustained the casualties of 2008 as
one of the foremost barometers that comes to mind. For transparent information on your FCM of choice you may refer to the CFTC accounting page at: http://www.cftc.gov/MarketReports/FinancialDataforFCMs/index.htm .The big advantage of trading
in the futures market of course is the ability to hedge a position with options
contracts which is a feature that FX platforms do not allow. In the case of
hedging the trader has more options to temper the fallout of a big movement
against the current position. Rule #1 is always to make a plan and Rule #2 is
always to stick to the plan and Rule #3 is to allow a clearly defined path to
an exit should things go wrong. The feature of trading currency options with
accounts at FCMs on exchange traded products clearly defines Rule #3.
Where are we now?
Where are we now?
The following technical charts of the futures GBP, EC and USDX for the nearest cash contract, being the June 2016 contracts, clearly define the current perspective where GBP and EC are exhibiting recent relative strengths > 40 and the USDX strengths < 40. In the weeks to come a sideways channel of trading is anticipated as the precursor to the vote event on 23rd June 2016. Therefore the GBP and EC are expected to drift lower and the USDX higher just before the vote. Courtesy Omega research as follows:
GBP
EC
USDX
GBP
EC
USDX
Putting on a Straddle
Now
let us assume that a small trader wishes to open a position prior to the
referendum vote on GBP/ USD and EUR/USD with the view to resuming activity on
an FX platform in the aftermath and only engage in FX spot trades on these platforms once a
clear sense of direction has been determined in the days succeeding the vote.
Through
a trading account with an FCM a small trader can take a look at forward option
pricing. Today’s date being 4 April 2016 we are a good 80 days out from the
epic 23 June 2016 date of the referendum.
Based on this mornings prices on market open on 4 April 2016 the prices of Options for BP (British Pound) and EC Euro Currency Unit) and strike prices as close to the respective futures price would be summarized as follows for a straddle of equal strike price for call and put option:
BPU16 (sept16) future trading at 1.4227.
CBPU161425 - call 1425 price 0.0514 +$3,212.50
PBPU161425 - put 1425 price 0.0537 +$3,356.25
ECU16 (Sept16) future trading at 1.1455
CECU161145 - call 1145 price 0.03050 +$3,812.50
PECU161145 - put - 1145 price 0.03010 +$3,762.50
As the expiration of June currency options on the CME fall on 3rd June 2016, prior to the UK vote on the 23rd June 2016, then we will have to take a closer look at the next set of options which expire on 9th September 2016. Furthermore, since today marks some 80 days to the referendum event and the September options contract carries some 90 days additional, therefore the intrinsic and time value of the option is going to be very valuable but the purpose of the option is well-suited as an entry point before the vote. Time decay will not erode rapidly and come the date of the vote the straddle should be able to identify a purposeful momentum sufficient to carry the cost of losing the eroding value of the negative leg of the straddle. Given the large time value of the options the purchase price of the positions is well retained to the moment of the decisive vote on 23rd June 2016.
and similarly
By taking the straddle a trader can take advantage of the lull that should occur as GBP and EC trend sideways. Hedge funds look to options contracts OTC and exchange traded very much as reconnaissance scouts to look ahead and explore decisions as new trends emerge in the aftermath of the vote event. Similarly the small trader could use the straddle of call and put option at equal strike price as a safety measure given that the market as a whole for GBP and EC may tend to trade sideways as the market awaits the outcome of the vote with explosive direction.
Following the vote
A key to understanding the new direction should appear over the next 2 days of trading after an event as momentous as the Brexit. The Brexit event should carry a large price range of action which would expand upon the contracting price action preceding the vote. Characteristically the preceding 5 trading days may resemble a narrowing range of price action quite similar to how prices tend to narrow preceding an important data release like the NFP where all trading comes to a silent and pregnant pause. in similar fashion in placing the straddle the trader hopes to capture the explosive momentum of a new breakout. The days following the breakout may either set a new trend direction bearish on the GBP and EC or spurt in an opposite positive direction before running out of steam fast only to retrace and resume a preceding long term trend of negativity on the GBP and EC.
Option 1 scenario would have hedge fund pushing momentum lower with succeeding lower lows in the days after the break out as a sustained push stretches out for the balance of 2016 and Option 2 scenario may see hedge funds taking a quick profit pushing the GBP and Euro currency upwards on a shorter time frame of 3-4 weeks before the euphoria runs out and traders come to terms with the under-lying economic reality of interest rates, gnp growth, inflation, unemployment etc that makes up the features of the Us economy vs the UK and the Euro zone and retracement begins for a lower GBP and Euro currency. A new trend having been identified in the 2 days succeeding the vote will enable the small trader to resume on the FX platform and accumulate spot positions in the direction identified by the positive leg of the option straddle.
We shall follow closely options volatility over the next 8 - 10 weeks as prices on the GBP and EC would attempt to narrow and trade sideways preceding the vote.
Thank you
Based on this mornings prices on market open on 4 April 2016 the prices of Options for BP (British Pound) and EC Euro Currency Unit) and strike prices as close to the respective futures price would be summarized as follows for a straddle of equal strike price for call and put option:
BPU16 (sept16) future trading at 1.4227.
CBPU161425 - call 1425 price 0.0514 +$3,212.50
PBPU161425 - put 1425 price 0.0537 +$3,356.25
ECU16 (Sept16) future trading at 1.1455
CECU161145 - call 1145 price 0.03050 +$3,812.50
PECU161145 - put - 1145 price 0.03010 +$3,762.50
As the expiration of June currency options on the CME fall on 3rd June 2016, prior to the UK vote on the 23rd June 2016, then we will have to take a closer look at the next set of options which expire on 9th September 2016. Furthermore, since today marks some 80 days to the referendum event and the September options contract carries some 90 days additional, therefore the intrinsic and time value of the option is going to be very valuable but the purpose of the option is well-suited as an entry point before the vote. Time decay will not erode rapidly and come the date of the vote the straddle should be able to identify a purposeful momentum sufficient to carry the cost of losing the eroding value of the negative leg of the straddle. Given the large time value of the options the purchase price of the positions is well retained to the moment of the decisive vote on 23rd June 2016.
and similarly
By taking the straddle a trader can take advantage of the lull that should occur as GBP and EC trend sideways. Hedge funds look to options contracts OTC and exchange traded very much as reconnaissance scouts to look ahead and explore decisions as new trends emerge in the aftermath of the vote event. Similarly the small trader could use the straddle of call and put option at equal strike price as a safety measure given that the market as a whole for GBP and EC may tend to trade sideways as the market awaits the outcome of the vote with explosive direction.
Following the vote
A key to understanding the new direction should appear over the next 2 days of trading after an event as momentous as the Brexit. The Brexit event should carry a large price range of action which would expand upon the contracting price action preceding the vote. Characteristically the preceding 5 trading days may resemble a narrowing range of price action quite similar to how prices tend to narrow preceding an important data release like the NFP where all trading comes to a silent and pregnant pause. in similar fashion in placing the straddle the trader hopes to capture the explosive momentum of a new breakout. The days following the breakout may either set a new trend direction bearish on the GBP and EC or spurt in an opposite positive direction before running out of steam fast only to retrace and resume a preceding long term trend of negativity on the GBP and EC.
Option 1 scenario would have hedge fund pushing momentum lower with succeeding lower lows in the days after the break out as a sustained push stretches out for the balance of 2016 and Option 2 scenario may see hedge funds taking a quick profit pushing the GBP and Euro currency upwards on a shorter time frame of 3-4 weeks before the euphoria runs out and traders come to terms with the under-lying economic reality of interest rates, gnp growth, inflation, unemployment etc that makes up the features of the Us economy vs the UK and the Euro zone and retracement begins for a lower GBP and Euro currency. A new trend having been identified in the 2 days succeeding the vote will enable the small trader to resume on the FX platform and accumulate spot positions in the direction identified by the positive leg of the option straddle.
We shall follow closely options volatility over the next 8 - 10 weeks as prices on the GBP and EC would attempt to narrow and trade sideways preceding the vote.
Thank you
Pieter
Bergli - Trader X16
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