Trading a Real Market: What the Swiss National Bank Taught Retail Traders | Hacker News Reader

Trading a Real Market: What the Swiss National Bank Taught Retail Traders

mechanicalforex.com

93 pointsca98am7974 comments

What the SNB really taught people this week is what emerging markets people have known for decades, and actually, developed markets traders really should know too. You should never trade a peg in the direction that is being defended by a central bank. You should almost always fight the central bank.

Anybody who takes a cursory glance at history will know this: ERM 1992, Russia 1998, Brazil 2001, and yes, Russia H2 2014 (semi peg). The examples of peg breaks are numerous, and some recent. No excuses.

A "grid trading" strategy that was essentially recommending picking up pennies in front of a steamroller, was irresponsible at best. One should always look at the balance of payments of a country to see if it is in surplus or deficit, and trade the currency accordingly. Swiss was in massive surplus on the capital account. This guy was recommending selling swiss francs for a tiny, marginal carry trade in euros.

And if you don't know what balance of payments means, you really should figure it out before committing money to the FX market.

Finally, all the bull about liquidity. Of course there is no liquidity when a market revalues suddenly. This is the same in equities: if an unexpected announcement happens, the price revalues instantly and there is no liquidity in between. It is a discrete event. Econ 101.

Complete agreement. If the central bank is defending a rate, "defending" means spending money, and you want to be on the side that's getting the money. Simple. Russia has/had been pouring money into propping up the ruble, said money was received by FX traders with the correct positions. The worst outcome for central banks, which is frequently what comes to pass, is they spend a ludicrous amount of money defending their position and in the end they still lose.

Is there good data on how often they lose? Sure, I can think of plenty of examples of central banks being forced to give up their peg, but I can also think of plenty of examples where the traders betting against them lost out. You'd need to consider both if you really want to use historical data as a justification for trading. For example the EUR/DKK peg has been challenged on numerous occasions without success. China has also been fairly successful in dictating its exchange rates, with some currency movements but generally on its own timetable and very carefully controlled.

https://en.wikipedia.org/wiki/Black_Wednesday

It's an interesting question. Googling briefly I didn't come across obvious studies. I guess it depends on how you do the accounting. A week ago the Swiss National Bank had foreign currency assets of about 520bn euros or 624bn Swiss Franks. It now has asset of about 520bn euros or 520bn Swiss Franks. Is that a loss of zero which it looks like if you do the accounts in euros or 104bn Swiss Francs if you do it in Swiss Francs?

[Hi from Argentina!]

I agree, but usually the pegs in the other direction are more dangerous.

When the government has too many Dollars (or Euros) they usually have time to find a soft solution and change the conversion rate slowly. It's always easy to burn money.

When the government has too few Dollar (or Euros) the amount of reserved money go down, they exchange the real money for valueless internal bonds, and one day they get up and they don't have any money left in the treasure and they are forced to make an abrupt correction.

So this suddenly change is strange. YMMV.

Good point, and China has for years adopted this approach. Problem is, they are now long of a trillion dollars of US debt, and are as a result, at the mercy of their own debtor. I think the Swiss were wary of that scenario: becoming longer of European debt. If they had adopted a gradual approach, they would have been showing their spoof poker hand, days after having asserted that the peg wouldn't move. The market would have sold billions more euros to them which they didn't want.

There is a good section about currency bands in Nassim Taleb's first book, Dynamic Hedging. It's a fairly technical book about risk management for options traders, but the section on Market Barriers is particularly germane.

I think it's valuable in the sense that it gives you a window into the way a skilled risk manager views the world versus the naïveté of retail traders. This was only a "black swan" event if you had no idea what you were doing.

https://books.google.com/books?id=-5-OldaTjVQC&lpg=PA227&ots...

His advice is all well and good but "skilled risk managers" can be just as dumb as everyone else. This has been proved multiple times in just the last few decades alone.

His advice is all well and good but "skilled risk managers" can be just as dumb as everyone else.

I work at an investment bank and I can safely confirm that most professional investment managers and risk managers fall for this type of stuff all the time.

If you want an example, look as Nassim Taleb's idiotic moves. Here's just one from 2010:

http://www.moneynews.com/StreetTalk/Nassim-Taleb-Shorting-Tr...

So in 2010 Taleb's advice to short U.S. Treasurys. How'd he do in the last 5 years? If he followed his own advice then he lost almost half his money on that trade as US Treasury rates fell dramatically since then.

I'm not picking on Nassim Taleb. He's a smart dude. But everybody - everybody - makes dumb investment decisions.

> I'm not picking on Nassim Taleb. He's a smart dude.

No, but you should pick on him, in a public-figure kind of way, I mean, not personally. He very publicly said (I paraphrase) "all macroeconomics is nonsense, you should short treasuries". His advice ran against solid macroeconomics and was demonstrably wrong. It wasn't just "dumb" advice, it was advice that deliberately ignored all sense and deliberately plumped for a dubious economic theory.

If I said something really stupid, I would expect to be called out on it. In general, I think, people would be better off if bullshit got called out.

Just because it didn't come to pass, doesn't mean the risk wasn't real.

By that logic you can never prove any prediction wrong. I think you're setting the bar too low.

“You have a very small probability of making money,” he said. “But if you’re right, you’ll never see a public plane again.” -Taleb, on shorting treasuries

Maybe not important, but in the video minimax linked to in another comment, he said that about buying far out of money options on precious metals to bet on hyperinflation happening, not shorting treasuries to bet on rising rates.

Shorting treasuries in 2010 was a popular sentiment. I'm sure you could have found a similar suggestion in the WSJ at the time. It is extremely unlikely, given Taleb's background as an options market maker, that he would have expressed that trade simply as an unhedged position in cash treasuries or the futures while he sat bleeding money for five years straight. It's an important distinction to make and I think it comes back to my original point about risk management. It is one thing to make a prediction and it's a separate step to then formulate a trade that captures upside if your prediction is correct and limits your downside if your prediction is incorrect. From a trader like Taleb, I think that's implicit in his statement, but maybe it wouldn't be so obvious to a layperson.

Taleb was very precise in what he said, and he didn't say anything like what you are attributing to him. There wasn't any real nuance, he really just said it was a good idea to short treasuries:

http://www.bloomberg.com/apps/news?pid=newsarchive&sid=azLmk...

http://noahpinionblog.blogspot.ca/2014/01/of-brains-and-ball...

Taleb has written literally hundreds of pages on risk management and if you don't consider any of that as context, I guess you could assume he literally meant to get short some delta one treasury product. I think that's a little bit naive but whatever.

You can watch the full video here: http://2010.therussiaforum.com/news/session-video3/

You have to switch it from Russian (ру́с) to English. He says you want an "active position" where you "benefit from rise [in rates]." The video then shows Hugh Hendry, who has basically the opposite position but for European government bonds. He is short rates (so long bonds) but he has an options position which fixes his maximum loss at some known value. Hendry spells it out, but I think given Taleb's background, he probably meant something like that (but in reverse).

Okay, I watched a bit of the video now (thanks for linking to it). I still don't see what's so ambiguous about "stay short Treasury bonds", he says it quite directly, and as far as I can tell from the video he means it, but maybe I'm wrong. He also says in that video says you should buy deep out of money options on gold/other metals in case hyperinflation happens.

So first, as far as I can tell, he really did say and mean those things.

Second, the suggestions, the bet on rising interest rates, as well as the bet on hyperinflation, are, I think, ignoring basic macroeconomics, and they pretend that some really implausible outcomes can happen. Maybe you would hedge the bet, and have other trades that bound your losses, but they would still have lost money. I don't think it matters that much that with a cleverer execution they would have lost less money. The point is that they were wrong in the first place.

You talk about basic macroeconomics, the way someone might talk about 'basic finance.' I think that's the whole problem...

He says you want an "active position" where you "benefit from rise [in rates]."

Rates went down dramatically. In fact, they were cut almost in half. He was completely wrong on this prediction over the last 5 years. Maybe he was early - doubtful - but over a 5 year time frame that's as good as wrong.

but he has an options position which fixes his maximum loss at some known value

If you are long an option then it fixes your maximum loss at some known value. If you are short an option, then your maximum loss is infinity.

But let's be real. Even if you are long an option, that option will expire. Over 5 years you probably rolled that option a minimum of a few times and more likely several dozen times. Almost every time you would've experienced a loss.

Why is it bad to admit that he Taleb was just spectacularly wrong on this position? (Just like 99% of other professional investors that expected rates to spike up dramatically from 2010 to 2015).

Not to kneejerk defend Taleb, but I believe his stated position is that he loses money on his trades almost all the time, and then makes it all back and more when a black swan event occurs. I don't believe a black swan has occurred in the treasury market in the last 5 years, so it would be interesting to hear if he's still waiting for one there.

That sounds insane. How can you wait for a black swan to clean up all your losses? That's a strategy? By definition, a black swan is unpredictable.

There is an extensive Wikipedia article[1] on this topic. Here's an excerpt:

   In economics and finance, a Taleb distribution
   is a returns profile that appears at times
   deceptively low-risk with steady returns, but
   experiences periodically catastrophic drawdowns.

The general idea is that because black swans occur infrequently, their risk is significantly under priced by most people.

NB: Taleb does not advocate investing using a Taleb distribution; instead he warns against that sort of investing.

[1] https://en.wikipedia.org/wiki/Taleb_distribution

By definition, a specific Black Swan is unpredictable, but in general the likelihood of any Black Swan event is higher than the markets factor in.

You'll never pick the day it happens. But if you invest everyday, eventually you'll be right (according to the theory). Take a trade that will almost certainly lose you 1% per annum BUT, in a Black Swan event will return you 1000%. Every year you 'bleed', and it takes guts to keep investing. Then one day something hits the fan, and you were the only one exposed to the upside.

Sounds like a naive implementation of venture capital investing. But I like VC's upside better.

If you're interested, here's a good article behind rationale and personality of Nassim Taleb's strategy. http://gladwell.com/blowing-up/

Everything in options trading is probability-based. So you can either buy a $1 lottery ticket that wins $1000 for 0.01% time, or sell a $1 lottery ticket to one counterparty that may only be redeemed for $1000 for 0.01% of time.

So for the lottery buyer, you know you're going to lose most of the time; so you size your bets accordingly to your expected value (formally known as Kelly's Criterion) to ensure that you still have enough stake while you're losing most of the time to keep betting and win in the long run when your loss rate regresses to the mean probability.

Likewise, the lottery seller's P&L profile is like an insurance disaster company. On most days, you steadily collect the insurance premium from your policyholders. But you have to size your "risk pool" and watch it carefully to ensure that you are well-capitalized to be able to pay out insurance claims when disasters hit. And if your expected value, again with Kelly's is no longer viable, you'll have to either sell your insurance policies to another trader or buy a hedge to re-insure yourself (formally known as keeping delta, gamma or vega neutral depending on the risk type in the options market).

Nassim Taleb's strategy involves mostly buying option straddles on indices and also large-cap blue chips. With options, based on expiration date and the current market's implied volatility, he can pick and choose accordingly the daily "loss rate" he is willing to take and also more importantly, what he thinks the market's "real volatility" level should be over the current "implied volatility" expressed in the options pricing.

So by sizing his bets properly, choosing an option series that limits his daily decay and expresses his opinion about volatility, he is able to make money over the long run (e.g., 2008 when the market mispriced volatility and VIX shot up to 200 and SPY went down a lot; his straddle gained in both implied and realized volatility).

One difference between professional traders and amateurs is that pros don't judge a trade by its outcome but by the idea and its execution. What makes something a good trade is if it is a good idea at the time based on the available information. But even the best idea may not work out and that's where risk management comes into play. Conversely, you can also make money on a bad trade, but it's still a bad trade. A professional trader's job is not to predict the future but to make good trades.

Taleb's idea may have been good at the time that simply did not work out. Of course, his statement tells you nothing about the concrete implementation of this idea which more often than not will make all the difference w.r.t. a trade's outcome. Maybe he even did actually make money from the idea. There's really nothing to suggest that he would have shorted in 2010 and just held the position since then.

Not everyone was surprised by the SNB's action. I haven't seen the following discussion reported widely. I only have a link to a video, no transcript. But it's short, little over 1 min in length.

Some smart money started moving into CHF last month. More interestingly, there was a lot of movement about one minute ahead of the announcement.

http://finance.yahoo.com/video/traders-knew-snb-move-pro-060...

Here's the ending:

   Announcer: despite everything we've heard about
   manipulation of foreign exchange markets, about
   the deep forensic look into these markets,
   you're saying there was action before the
   announcement which indicates there was some
   parties in the market that knew this. I want to
   be categorical about this.

   Guest: It definitely looks like that to us.
   There was a movement in the market well ahead
   of the headlines, and a huge flow throughout
   December, an unprecedented flow, in the leadup
   to yesterday's break of the peg.

It was bad form for the SNB to say they were committed to the peg and then to scrap it a few days later. On the other hand it shows how entitled markets have become to having central banks telegraph their strategy to the world. Would monetary policy & markets ultimately work better if we didn't expect central banks to be so blatant about their future moves? At the very least it would shake out the dangerous complacency that leads to overcrowded trades & heightened contagion risk.

> It was bad form for the SNB to say they were committed to the peg and then to scrap it a few days later.

I may be wrong, but I think the decision to get rid of the cap was ultimately the result of an ECJ's judge statement made the previous day: http://www.telegraph.co.uk/finance/economics/11344253/ECJ-ru... , so not much that SNB could do about it.

But that decision was about ECB's QE, I don't think this is as clear as you make it sound. SNB could have chosen to continue the peg through any ECB actions, but instead they chose to scrap it. It was still their decision, although you can argue that they wouldn't have been successful had they decided to continue the peg.

So this is slightly deviating from topic, but still on it. Can someone explain why forex has looked like shady stuff for so long and there are so many get rich trading forex ads all over the web? I have never dug into this, so I am just genuinely curious. How does that industry work?

Lack of regulation. You can go to jail for advertising equities, futures, bonds, etc. like these bucket shops do.

When you have 50x or 100x leverage, you will either get rich quick or go to zero quick.

> so many get rich trading forex ads all over the web Anecdotally, as a publisher, the CPCs (cost-per-click) are quite high, likely to make up for low clickthrough rates.

In other words, it doesn't seem like many people are interested in it, but the forex shops must be making fairly good money when they get a new customer.

tl;dr it's high-margin and low volume in terms of actual customer counts.

Pull people in, lose all their money via high leverage (stop them out when they lose), repeat with new sucker. You have to get new customers to pillage constantly, hence the advertising. Plus it is more or less unregulated (leverage is limited to 50x in US, unregulated elsewhere). The companies dont have to hedge the positions much, as many net out, and people will mainly be losing money.

Forex trading in itself is a fairly neutral, close to zero sum process. The people running forex adds get rich by charging commission on trades and selling get rich courses. Most small speculators lose their money. I guess it remains popular because it's not a total losers game - well informed speculators like Soros can make a great deal of money at it.

There is almost no regulation (insider trading is fine for example). Leverage is huge so it draws in the get rich quick people. FX has dealers instead of brokers, and I'm told from friends who have dabbled in FX trading, feels like a conflict of interest.

http://www.investopedia.com/articles/forex/06/sevenfxfaqs.as...

Not a trader certainly not forex but the blood was in the water the day the Swiss decided to peg. Certainly they had their reasons - to keep the franc from becoming too strong - but as other commenters have already explained pegs are too difficult to defend and in this case, the EU was nowhere near a consensus on monetary policy. I like the "picking up pennies in front of a steamroller" analogy it fits the situation perfectly.

And that is why you make high-risk trades with options, or not at all.

I don't think I understand how currency trading works. If you owned EUR the value of the EUR only changed relative to the CHF. If you owned CHF you gained 15% against all currencies.

How do people lose money on this? Are people somehow trading on the CHF/EUR exchange rate? And is so, why? The CHF was pegged to the EUR.

It reminds of when people were still trading shares in Genentech for years when Roche had an option to buy all GNE shares at a certain price, which they of course did eventually.

Is this another example of people trading without full knowledge?

A typical, very trading strategy was used by many people (including the biggest absolute return fund in my home country) and robots as well:

- CHFEUR floor is 1.2 (or that's what everybody thought)

- so you short the CHF @ 1.2

- side effect: your money is essentially stored safely in a position that has no downside but has upside (or so you think)

- if, for any reason, CHFEUR is >1.2, then you exit your short position with some profit

- when CHFEUR is back to 1.2, then do the same again.

Works brilliantly, until the black swan flies through your window, and everything is full of shattered glass. So in short, people relied on the SNB's promise, they thought there's zero risk of this thing happening (i.e. removing the floor without notice), and took positions that had small upside with ~1 probability and huge downside with ~0 probability. At least they have a good story to tell now.

So you are trading on the exchange rate? What's happening in the background? I guess someone is writing these option contracts and backing them with real currency?

In the background, the SNB was printing francs and purchasing Euro's to keep the EUR/CHF at the 1.2 Peg. They stopped doing that two days ago.

You can do that in many forms. You can go to a (daytrading) firm who either actually buys exactly what you tell them, or they pool up the clients' positions in some way to decrease their transaction costs. FX market is extremely liquid and fully automatized, settlement is usually done in batches but retail clients do not need to worry about that. Obviously there are contracts behind this, but there's no need to write a new contract every single time.

There are other forms of FX trading. For example, you can go to 'betting' sites to bet on currency rate movements -- for example, in the UK this is usually better for retail clients than normal FX trading as the profits fall under betting profits and not trading profits, and the former are lower. (Ridiculous, I know.)

In the background you have a loan in one currency, secured by the cash in the other currency.

What's happening in the background?

In lower-end forex shops, you're simply authorizing your broker to calculate how much money you would have won or lost had the trade actually occurred and debit/credit your account accordingly. No foreign currencies change hands and no financial instruments are implicated.

These are called "bucket shops" and they're so slimy that Bitcoin exchange operators feel obligated to describe that they're not like them.

Wow. The more things change, the more they stay the same.

More than a century ago, Jesse Livermore[1] made and lost several fortunes trading stocks via bucket shops. Not unlike what happens to current day card counters, the bucket shops banned Livermore. Bucket shops (at least for stocks) have long been illegal in the USA.

[1] https://en.wikipedia.org/wiki/Reminiscences_of_a_Stock_Opera...

What exactly is slimy about it? It's all based on a published exchange rate, right?

The original bucket shops were only slimy because they could have real traders at the exchange manipulating the price to wipe out customers in the bucket shop. (as far as I know)

To me, it seems slimy because the shop could find itself unable to pay out the money it owes to customers.

The issue is leverage. [1] [2] In order to trade $1mm worth of EUR vs CHF, you didn't actually have to have $1mm. So, if the CHF, for whatever reason, increased above the SNB peg of 1.2, you could then trade $1mm for, say, $10,000 in your account (100:1 leverage). Then, if there is a 1% move back to the Peg, you profit 0.01 x $1mm, or $1,000.

The reason brokers will give you this much leverage is that ForEx (up until a couple days ago) was one of the most liquid markets on the planet. If you hit a margin call, your broker could instantly liquidate your entire portfolio to cover any loss, with very little risk.

And then, the SNB walked away from their Peg, and the earth collapsed underneath all these traders (and brokers in some case) - All these traders/brokers who thought that a position could be liquidated at minimal loss, ran into a market with a scarcity (absence) of buyers, and were wiped for the entire value of their accounts (and more - lots of traders ended up with a negative position)

This is a wakeup call that people will remember or a very, very long time (and should have been learnt in the 2008 Mortgage collapse) - the potential for a black swan event is everywhere.

[1] http://www.investopedia.com/ask/answers/06/forexleverage.asp [2] http://www.investopedia.com/articles/forex/08/margin-leverag...

A 1% move would net you $10k, not $1k. That's why it's so alluring. You can gain (or lose) a lot when you're leveraged at 100:1 (as most retail FX brokers allow) and the currencies move just a small amount.

FX for the common man is recent. It's the new housing: access to leverage.

This makes me wonder. Aren't those retail investors all indebted to FXCM now ? They mostly made the bets using the platforms, (I assume) very little bets were made by FXCM itself.

Correct. "FXCM Inc. (FXCM), which handled a record $1.4 trillion of trades by individuals last quarter, said clients owe $225 million on their accounts after the Swiss National Bank’s decision to abandon the franc’s cap against the euro roiled markets worldwide." http://www.bloomberg.com/news/2015-01-16/fxcm-faces-losses-o...

Or if you have a FX-denominated mortgage (common in Hungary), you can have both!

I don't think this is a 'black swan' event. The strategy was pretty explicitly premised on a binary event: the Swiss bank keeping the peg or not. It didn't. As OP indicates, the possibility of the peg breaking was understood by anyone who actually understood the trades they were making. And it's not like central banks have never failed to keep a peg in the past...

Because a lot of people including institutions like Goldman Sachs and the FX brokers were short-selling the CHF (selling borrowed CHF on the open market hoping to pay it back at a lower price denominated in another currency). Except the trade went against them because it was worth more denominated in other currencies. What I don't know myself though is how they were expecting it fall if it was pegged. Perhaps they announcement coming but thought it would fall in price instead of rise.

> I don't think I understand how currency trading works. If you owned EUR the value of the EUR only changed relative to the CHF. If you owned CHF you gained 15% against all currencies.

> How do people lose money on this? Are people somehow trading on the CHF/EUR exchange rate? And is so, why? The CHF was pegged to the EUR.

When you currency trade you go long one side of a currency pair and short the other. So you borrow 40000 Euro and buy Franc or vice versa. There is always a specific currency pair involved.

The usual reasons to take a position in a pegged currency is either to bet that the peg breaks (which people being long Euro obviously didn't do), or to extract value from a difference in interest rates (the carry trade, I don't know if that applied but there must have been something attractive about shorting CHF....)

Thanks. That makes sense to me.

In FX you are always trading one thing against another. There is a long position, and a short position. In this case, you were long EUR and short CHF. When CHF revalued 15%, you had to pay many more euros to buy back your short. So if you started with 100 EUR long, 120 CHF short, at the pre-break exchange rate of 1.2, then when it "cracked" to say 1.05, you had to pay 120/1.05 to repay your short. That's 114.2857 EUR you had to pay back, but you only had 100 EUR to start out. Thus you lost 14+%.

By the way, poorly explained in the main post: most of the stops actually happened way below 1.05. The cross panic-traded down to 0.85 in the hour after the reval announcement, which is where most of the stops were occurring.

1.2/0.85 - 1 = a 41% loss.

Imagine if you were leveraged 100x......

Alpari offered leverage up to 500x. Craziness.

> I don't think I understand how currency trading works.

You're right, you don't, and it's too big a topic to explain in a comment, but basically yes people trade the exchange rates because they can and because if you do it right it's very profitable. You don't ever own either, currency trading is pairs trading where you're long one and short the other to open a position and exiting a position exits both trades which looks like a single trade to you.

George Soros once made a billion dollars shorting the GBP and forced a country to remove a floor, similar to what just happened here.

The EUR/USD has been sinking like a rock for most of the year, so traders short it, wait for it to sink more, and cash in their profits. It's just like trading stocks except you have more liquidity, more leverage, and going long/short are basically the same because these aren't stocks and going short the EUR/USD is identical to going long USD/EUR.

As others already mentioned, you always trade currencies in pairs. By breaking the peg anyone on the wrong side of the pair lost. Since currencies move very little, most currency trades are highly leveraged. A 20% move in a day basically wiped out entire fortunes.

The other people who are exposed are those who took out swiss franc mortgages from other countries[1]. I'm amazed this was even allowed, but up until now the franc was stable and the rates low so it made some sense.

[1] http://www.economist.com/news/europe/21639760-poles-were-slo...

> It reminds of when people were still trading shares in Genentech for years when Roche had an option to buy all GNE shares at a certain price, which they of course did eventually.

Why do you think people would stop trading Genentech shares?

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