Trading the EU Referendum: Risk-Reward Ratio Skewed Towards Plain Nasty, Hideous or Disastrous

Why trading the markets around EU referendum day is probably not the best idea.

Like many other market specialists, analysts at Financial Spreads, the London-based financial spread betting firm, have been looking at how investors could trade the referendum profitably.

For short-term investors it is tempting to trade the UK referendum as the volatility is appealing.

However, the volatility we could see over the next week could be of a different magnitude.

Indeed, we have noted here that volatility in EUR/GBP is back to 2008 financial crisis highs.

Meanwhile, implied volatility on the GBP/USD exchange rate suggests a gaping potential range of between 1.32 and 1.51.

“This probably makes the risk-reward ratio skewed to towards results of plain nasty, hideous or disastrous,” says Adam Jepsen, the founder of Financial Spreads.

Jensen has today written on how retail traders face two notable problems, and what they could do to navigate the problem.

Problem 1: What Will the Markets Do?

The result of the referendum is far from clear.

Even if you correctly predict the result you then, as usual, have to predict the market reaction.

Theoretically, a win for the Remain campaign would boost the FTSE 100 and Sterling notes Jepsen.

Of course, the theory quickly breaks down if the market has partially priced in that result.

Indeed, the most read piece on Pound Sterling Live at present is a piece detailing the potential surge in the GBP/EUR exchange rate on Brexit. Who would have thought!

Jepsen notes that it is often said that the financial markets will move in the direction that hurt the most people, this could be another example of that.

Problem 2: Extreme Volatility

Now it gets tricky argues Jepsen:

"There seem to be a lot of people and adverts saying this is a great trading opportunity but the wild swings could be too much for all but the deepest of pockets.

"Even if you correctly predict the result of the referendum, and the broader market reaction, there will probably be a lot of volatility.

"The markets could easily spike against your trade and close your position before you can make a profit. That would be plain ugly."

Of course, extreme volatility is a distinct possibility. If a markets moves against you it could gap to a completely different price level.

That could leave you in the hideous scenario of wiping out all the funds in your trading account.

Worse-still is a disastrous but plausible price move that leaves you in debt.

At the moment, the markets feel like a lot of tightly coiled springs.

Also, in the options markets it's realistic to assume there are some very big positions that could be triggered and send markets spiking.

George Soros's 1992 $10bn short of Sterling could be common place.

Joe Rundle, Head of Trading at ETX Capital, agrees with his industry colleague at Financial Spreads noting, "for traders the biggest thing to contend with is that the result is being announced on a normal trading day – a stock market meltdown is not impossible if the vote goes against Remain. Enormous gyrations in stock, bond and currency markets is an almost certainty."

The Solution: Wait it Out

A simple solution is to sit on your hands argues the Jepsen:

"Forget trading the referendum, the risk-reward ratio is probably not in your favour.

"Just watch Euro 2016, take up a hobby, learn how to play Minecraft, take care of that errand you've been putting off for two months or finish the DIY you've been putting off for two years.

"There will be plenty of trading opportunities after the result has been announced and the markets have had a little time to calm down."

Indeed, big-name asset managers appear to already be exiting the market.

Baring Asset Management's Head Of Global Fixed Income Alan Wilde says he has closed his short sterling position "to go flat" and added long gilts to go neutral.

Should the British vote in favor of leaving the European Union on June 23, it would "unleash huge amount of uncertainty" for the UK and the European Union, leading to safe haven flows into U.S. Treasuries and the U.S. dollar, and perhaps also the Swiss franc.

While he is still weighing up trades to protect his global portfolio Wilde says he has "not done anything yet as the vote looks too close to call."

According to Lars Henriksson, FX Strategist at Handelsbanken, beyond the initial reaction of the vote being announced, risks should be fairly symmetrical: that is, a decision to stay may strengthen the pound almost as much as a decision to leave might weaken it.

But the volatility of the first week will certainly be higher if Brexit wins.

"Be prepared for big swings in the market. The best recommendation we can make at this point is to do what you need to do in the FX market before next Friday. If the outcome is close, results may not be final until 08:30 on June 24, otherwise earlier," says Henriksson.