Assumptions

Assumption is the mother of all fuck ups….

The recent fall out from the movement in the CHF has been interesting to watch. If ever you wanted to clear out the retail FX space I dont think anyone could have come up with a better plan than the actions of the SNB, it was a wonderful nuking of an entire industry that probably needed a good enema. It will also give some comfort to those who were annoyed that most of these firms would trade against them using their B book and in doing so they sealed their own fate. As much fun as it has been it has caused me to pause and think about some of the assumptions I use in trading and whether they were ever valid. Within FX trading it was always assumed that the depth of the market would save you, therefore, slippage was not an issue. In fact most discussions of slippage being a potential problem were dismissed out of hand. The same was true about the assumption of needing tremendous leverage. FX is not like stock trading where it is theoretically possible to buy a stock at $1 and have it run to $20. Hence, it was necessary to leverage positions up to generate an effective rate of return.

I dont think either assumption is necessarily invalid in the light of the actions of the SNB. However, no one ever considered what would happen if a quote provider simply stopped offering a market. It needs to be remembered that retail FX is an unregulated market in the sense that there is no central governing body. When a firm is making markets in a given pair it is not analogous to when an options market maker is generating quotes in say BHP.  Market makers on regulated exchanges have a series of quoting guidelines they need to adhere to – these will never be perfect but they cannot simply abandon the market.

Given that it is not an unreasonable expectation that a firm you deal with would firstly manage its own internal risk correctly and secondly enable you to keep dealing the question needs to be asked as to how does the events of recent days impact upon the way we trade. To get a sense of how likely this sort of failure is Matt Levine at Bloomberg did a more comprehensive job of looking at the probability of a complete market meltdown in a pair such as EUR/CHF. His job is more complete than my simple guess and my guess looks like it was out by several orders of magnitude. Levine found the following –

Goldman Sachs Chief Financial Officer Harvey Schwartz said on this morning’s earnings call that this was something like a 20-standard-deviation event, and while the exact number of standard deviations is of course a subjective matter, that’s the right ballpark. Over the 12 months ended on Wednesday, the annual volatility — that is, the annualized standard deviation of daily returns — of the euro/franc relationship was a bit over 1.7 percent; over the last three months of that period the volatility was less than 1 percent.  That converts to adaily standard deviation of something like 0.1 percent.  On Thursday, the euro ended down almost 19 percent, or call it 180 standard deviations, depending on what period you use.

An 180-standard-deviation daily move should happen once every … hmmm let’s see, Wikipedia gives up after seven standard deviations, but a 7-standard-deviation move should happen about once every 390 billion days, or about once in a billion years.  So this should be much less frequent. Good news I guess, Switzerland won’t be un-pegging its currency for at least another billion years, go ahead and set your Swatch by it.

However, this raises another question which is a bit beyond the scope of what I am talking about and that is whether it is sensible to have rational expectations at all regarding the behaviour of markets. This is a debate that is currently being fought between traditional economists and behavioural economists. My own view is that markets have a somewhat skewed rationality – that is since they are made up of people then anything can happen and you can adopt rational framework for interaction with the market based upon this assumption. However, we are back to the notion of assumptions.

Assumptions are the only mechanism we have of dealing with markets and it is reasonable and rational to assume that some events will occur with extraordinary regularity and some will occur very rarely. However, it is always worthwhile to see whether the assumptions you have built your system on make sense and whether you have a back up plan if they fail. For example, I make certain assumptions about where prices will be filled in my options trading and the majority of the time I will be filled at or near the price i have stipulated but there may come a time when I am not. It is this event I need to plan for and make certain my Plan B enables me to fight another day. As abalone divers are prone to saying, it is not the shark you see that kills you but the one you dont see.