1992, just a year and a half after Britain joined the European Exchange Rate Mechanism or ERM, the fixed exchange rate posed a serious problem. The ERM was a precursor to the EURO and was created in 1979. Countries weren’t ready to give up their national currencies, but they agreed to fix their exchange rates with each other instead of “floating” their currency and letting capital markets set the rates. The ERM ensured the British government would follow fiscal and monetary policy that would prevent the exchange rate between the Pound or GBP and the strongest currency in Europe the German Deutsche Mark (DEM) from fluctuating by more than 6%. The exchange rate was set at 2.95 DEM to the Pound, therefore if the exchange rate ever neared the bottom of its permitted range DM 2.773, the government would be obliged to intervene. With fixed exchange rates, countries can’t just “set it and forget it.” People trade currency every day, exchanging their currency to buy imports or sell exports, and the market applies pressure based on what it thinks the actual rate should be based on supply and demand for a currency.
Between 1990 and 1992 the ERM had a positive effect on the British economy, inflation decreased, interest rates eased, and unemployment was low by historical standards. In 1992, however, England felt the impact of a massive global recession, and unemployment spiked to 12.7% from just 7.7% two years prior. Britain also had a large current account deficit [the country was importing more than it exported].
Ordinarily, Britain could spur investment and spending by cutting interest rates during an employment crisis. But in this case, doing so would push the pound’s value below the agreed upon amount within ERM. So while the people of Great Britain dealt with a recession, the government’s hands were tied; they’d just have to ride it out.
In the Spring of ’92 George Soros was 62 years old and led the Quantum Fund, a hedge fund he founded in 1970 that bet on macroeconomic trends.
Since August, Soros and his Quantum Fund had been building a $1.5 billion position to bet that the price of Sterling would fall. The British government had full faith that it would not fall as the ERM would serve as an “autopilot” that kept the British monetary policy on proper course. The fundamental problem however was that Britain had joined the ERM at the wrong rate and the sterling was overvalued, meaning that the economy was stuck with a structural current account deficit.
The catalyst came on the 25th of August 1992, German central bank official Reimut Jochimsen, a Bundesbank council member, issued a speech saying that there was potential for realignment within the ERM. Sterling weakened. On September 10, an unnamed Bundesbank official was quoted as saying that a devaluation of sterling was inevitable. The pound fell. September 16th, 1992 President of the German Bundesbank, Helmut Schlesinger gave the interview to the Wall Street Journal saying he “does not rule out the possibility that, even after the realignment and the cut in German interest rates, one or two currencies could come under pressure”. Soros and the entire financial market took this to believe that the pound sterling was one of those currencies that could “come under pressure” and be devalued.
Stanley Druckenmiller a senior member of Soros’ Quantum Fund noted that their $1.5 billion bet against the pound was about to pay off and that they should consider adding to the position Soros agreed with “Go for the jugular” and instead of slowly building up a short position against the sterling, the Quantum Fund would short sell sterling on an unprecedented scale even by today’s standards. Doing so would not only help hasten the tumble of the sterling, but also increase the hedge funds profits.
What is a hedge fund exactly? A hedge fund invests capital to make profits. They spread risk over a number of assets including shares, property, bonds and currency to name a few. A fund may make around a 20% return on its investments, as not every investment they make is profitable. Hedge funds also use financial instruments to “hedge” against other risks in order to more clearly isolate the trade that they want to make. For those that are new to the market it sometimes occurs that simultaneously opening long and short positions, essentially taking both sides of the trade, closing the loosing side early and letting the winning side run.
Another thing hedge funds do (if they’re pretty sure about their trade) is to borrow funds and put even more money behind the trade. Naturally a hedge fund might make a little bit of money on each side. But if they use mostly borrowed money, they can buy a larger position without fronting much capital. So if you’re really sure a trade is right, you might borrow a lot of money to enhance your payday, this is known as leverage. As Soros once famously said “There is no point in being confident and having a small position.”
When it comes to trading CFD’s online many fall into the ‘hedging’ trap, without really understanding how to apply the method properly.
Let’s look at an example, a trader’s account has $10,000 in equity. $1 million dollar positions are opened long and short on currency X at 1.0000 (using $4000 margin assuming 500:1 leverage). At $100 per point all that is required to wipe out the account entirely is a movement in either direction of 100 points.
This can happen in the blink of an eye and bang the traders account has been ‘blown up’. The point is this: no matter how much equity in your account because leverage is involved face value exposure will always be magnified by a much greater factor (i.e. 500:1). And it must also be mentioned that leverage is a central component to the profitability of CFD trading in the first place.
For this reason most successful traders use some form of strategy with the following components, as did George Soros and the Quantum fund in 1992
1. Pick a market
2. Pick a direction
3. Set a stop loss and a take profit
Now lets look at an example successful way a trader can use hedging to increase or maintain their equity. A trader has 100 shares in company Y on the ASX, the only way our trader makes money is if the market is up and the price of the shares increase.
If the trader was to open a CFD trading account and open sell positions (assuming leverage of shares is 10:1) they would only need to sell 10 units to match the 100 physical shares. Then if the situation arose where the share price fell, the trader has protected his physical shares with the CFD sell position, meaning he will profit on the downturn and make up for the loss in the shares on the ASX.
If you are looking to learn how to use CFD trading to hedge your shares or other financial assets, call myFXplan today on +613 8393 1800 or visit www.myfxplan.com