In the last 24 hours, we've been bombarded with questions about the euro; mostly how could this happen in a world of electronic market transparency, and central banks telegraphing moves? The truth is, those two aspects are exactly why this happened.
Moderate exaggerations by the ECB lured traders into placing much larger wagers on Thursday's ECB meeting than were reasonably justified. Of course, such traders did so at their own will; placing blame on the ECB is giving traders a pass. Further, easy electronic access to the futures and FX currency markets have made it overly convenient to speculate in currencies. This, along with computerized algorithms, often work to temporarily push price to unsustainable levels.
Unlike applying for a job, or any other skilled task offering financial reward, anybody with a few bucks, a pulse and meager financial requirements can open a futures and FX trading account. Whether the trader attached to the account is sitting in a high-rise in Battery Park trading 1,000 contracts at a time, or is a millennial in his pajamas sipping on a cup of joe, jumping on the short-euro bandwagon was as easy as clicking a few buttons. And that is what they did. Who could blame them? All the talking heads were chirping about the currencies going to par (which occurs when the value of the dollar is exactly equivalent to a single euro). Also, for several weeks, being short the euro was easy money. Nevertheless, the thing about tables is they always turn; the same can be said of market trends and overcrowded trades. There is no such thing as a free lunch in trading; just when the masses believe there is, reality strikes.
Yesterday's euro rally had little to do with fundamentals. After all, the EU is certainly taking dramatic measures to stimulate its economy at the expense of its currency. It is now running at negative interest rates, and employing a massive quantitative easing program. Yet the euro rallied on the news; not because the news was bullish but because the euro never should have traded as low as it did in the first place and needed to reprice. Not only had the massive bearish bets placed by bandwagon traders already priced in an EU rate cut and what equates to money printing, they had essentially priced in even more. Thus, yesterday's bearish news for the euro currency suddenly became bullish.
I can assure you, those traders scrambling to buy back their euro shorts yesterday were not doing so because they had changed their opinion of the euro, they simply ran out of money, couldn't take the pain any longer or were being force-liquidated by margin clerks. Although the outcome likely would have been similar regardless, it is important to note that we are in the midst of the holiday season, which is a hotbed of inexplicable moves capable of ending trading careers. Thus, lighter-than-usual volume going into the event probably contributed to the volatility.
For the sake of full disclosure, I write this from the opposite side of the trade and a poor decision that prevented us from benefiting from the move. In anticipation of a short squeeze in the euro that we believed would put an end to the death spiral, we sold the December $1.05 puts on a relatively volatile down day in October. Luckily, due to the timing of our entry, losses on the trade were relatively minimal as the euro made its way lower.
However, the price of the euro was within striking distance of our short puts on Monday. In normal circumstances, we probably would have held tight, but in light of the event risk, we deemed it foolish to hold any short options with strike prices within 3% of the market. As we saw yesterday, the euro can move 200 to 300 ticks in a day if the setting is right.
We noticed the market was vastly overpricing options on both sides of the market, so instead of maintaining our bullish trade of being short puts, we decided to sell strangles (short $1.11 calls and short $1.02 puts). For those unfamiliar with the strategy, short strangles profit if the price of the underlying assets stays within the strike prices of the options. To make a long story short, our bullish bias was eventually proven correct, but our need to manage risk and stop the slow bleed caused by the bandwagon short-euro trade lured us into altering the position to one that had upside risk. In hindsight, this was a horrible idea ... but after 24 hours of adjustments, we survived what will go down in history as the second-largest euro currency move in a single trading session with nothing more than a few small bruises. Thank goodness it is Friday!