A pounding headache

    21 May 2016

    ‘In this world, nothing can be certain except death and taxes,’ said Benjamin Franklin, one of America’s founding fathers. And that’s good advice for anyone investing and trading. There’s no such thing as a ‘sure winner’ even if your broker or favoured share tipster promises you there is. Financial markets will rob you of that illusion both rapidly and expensively. But if there is a sure thing, then I’d bet that sterling will be exceptionally volatile around 23 June — referendum day.

    UBS estimates that sterling will rally 10 per cent if the UK votes to remain in the EU and fall 25 per cent if we vote to leave. For currency markets, these are huge moves. But UBS is not alone: Goldman Sachs and Nomura both expect sterling to fall 15–20 per cent if we vote Leave. The City view generally is that whether we vote in or out, sterling is likely to move up or down significantly — albeit more to the downside after an ‘out’ vote.

    So predicting volatility looks easy. But forecasting the referendum result is much more difficult. The polls are close, with a recent Telegraph survey putting Remain at 51 per cent and Leave at 46. Adding to the uncertainty, one-fifth of voters are still undecided or ‘soft’, meaning liable to change their minds. So if you can’t confidently anticipate the result but you think sterling will soar or plunge either way, then the trading position to profit from that view is to buy sterling volatility. Basically, you’ll make money if the pound makes a large move, whether it’s up or down.

    This trading strategy involves the use of options, a form of financial derivative far too complex to explain here: ask your broker how they work, and how much your minimum bet would have to be. Warren Buffett once famously called all derivatives ‘weapons of mass destruction’ but in the right hands — which means know-ledgeable ones — they do serve a purpose.

    Sterling volatility has already increased to 13 per cent from a long-term ‘calm’ average of around 8 per cent, according to John Hardy at Saxobank, but is down from a peak of 16 per cent. So just lately, sterling volatility has fallen and become cheaper: good news if you’re buying it. And if you believe UBS and think sterling could move up 10 per cent or down 25 per cent on the referendum outcome, then even higher-than-normal 13 per cent volatility is still cheap. But not every-one sees it that way: Michael Hewson at derivatives and spread-betting dealer CMC Markets thinks sterling’s decline on a Leave vote will be less than 10 per cent.

    Here a little history is useful. Go back to Black Wednesday, 16 September 1992, when sterling was ejected from the European Exchange Rate Mechanism. One pound went from buying just over 2.8 deutschemarks to buying just over 2.4 within three weeks: a 15 per cent decline.

    Is leaving the EU comparable to being ejected from the ERM? Will the fall in sterling be greater or less than the fall after Black Wednesday? It depends on your view of the UK’s success within or outside the Union, but I would argue that being thrown out of the precursor to the euro was not as damaging as leaving the UK’s biggest bloc of trading partners could be.

    Michael Hewson points out that the Bank of England spent tens of billions on the foreign exchanges in 1992 trying to support the pound. When the support stopped, sterling fell fast and furiously. The UK government is not currently urging the Bank to buy sterling: there is no prop artificially holding up the pound. But as John Hardy at Saxobank argues, that may not be the case if we vote Leave. It’s possible, maybe even probable, that the Bank would intervene to stop sterling falling too rapidly. If so, then that would limit the profits of going ‘long sterling volatility’.

    Jane Foley at Rabobank puts another spanner in my theoretical trade. If the UK votes to leave then that may drive the euro lower as well; because,where the UK leads other member nations may follow, leading ultimately to a break-up of the euro.

    If you’re still convinced of the merits of my sterling volatility trade, then the way to do it is via a ‘straddle’ or even a ‘strangle’: ask your broker about those too. But beware: options trading is not for the faint-hearted or the financially illiterate.

    As for me? After all this thought and research I’m reminded why I don’t trade. I’m also reminded of a great British saying: ‘You pays your money and you takes your choice.’ Which applies to the vote in June, as well as trading strategies.