National currencies usually don’t move very much. In western, developed economies, for example, a national currency might move only two or three basis points a day (where one basis point is the equivalent to a move of 0.01%). In the grand scheme of things, a two or three basis point move is relatively insignificant and you would be hard pressed to find a trader who is interested in such a trade.
That is, of course, before leverage is introduced.
You see, while currencies do not tend to move very much, they are still very attractive to traders because they are high in liquidity and they trade all the time – 24 hours a day, five days a week. That gives traders lots of opportunities to make their bets and make money.
But because currencies only fluctuate a tiny amount, leverage must be utilized in order to make it worthwhile. Without leverage, a trader who bets $200 on EUR/USD will see a miniscule return on a day’s typical movement. Forex brokers offer leverage of 100, 200, even 400 to 1, and in this way, a trader with only $200 to play with can now control as much as $80,000 in the market.
Leverage, of course, increases the potential gains you can make from a currency trade, but it simultaneously increases the risk too. If the currency in question suddenly moves by an amount that is outside of the normal range, the potential for gain or loss is increased exponentially.
The Swiss Franc Move
On the 15th of January this year, the Swiss franc diverged from its usual two or three basis point trading range, as a major unexpected event shocked currency traders around the world.
Instead of the normal 0.01% – 0.03% daily range, the Swiss franc jumped by over 30% against most of its major trading partners. The reason?
The Swiss National Bank (SNB) had just announced a surprise move to abandon the three-year currency peg that it had put in place to keep the franc tied to the euro, in a bid to stop the currency from appreciating.
Central banks are known for their careful wording of statements and their extra cautious approach to policy decisions, so this move was one that nobody in the currency markets had expected. And because of the lack of guidance and the extent of the shock, the Swiss franc rallied by an extraordinary amount.
One in a Million
Such was the extraordinary nature of the Swiss franc move, that there will no doubt be statisticians out there who will claim that the outcome was a one in a million type event. To some, the probability of such an event must be so minute that for most traders, it should not be worthy of consideration. However, such an answer will be of little consoloation to the hundreds, maybe thousands of traders who lost all their money (and more) from the event.
According to the forex broker FXCM, its customers now owe over $220 million as a result of the SNB move, while UK broker Alpari, and New Zealand broker Excel Markets, were forced into liquidation as a result of sustained losses.
Without doubt, these traders and brokerages were operating under an illusion and their risk control settings were set firmly within the normal range.
But Nassim Taleb, author of The Black Swan, has already taught us that humans only find simple explanations for long-tail events, after the fact. And David Hand, author of The Improbability Principle, taught us that improbable events happen all the time, much more often than we care to believe.
By ignoring these very real, long-tail risks, the traders and brokers that lost money from the Swiss debacle only have themselves to blame.
It just goes to show the exacting requirements of strict risk control and, not least, the importance of stop losses in the market. Those traders who did not put all their eggs in one basket, who had stops in place, most likely lived to fight another day. Those who saw the Swiss franc as the ultimate, “unbreakable” hedge for their trades did not fare so well.
The huge spike that occurred in the Swiss franc lasted only a couple of minutes and it put many people out of business. It was a major shock to almost everyone, and it led to businesses closing down, but it was not a one in a million event.
It was just another one of the extraordinarily, improbable occurrences that happen every day around the world.
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