1. Some thought about probability and the impact of free information
The exact time of an extreme event, like e.g. a market crash or the apocalypse, cannot be foreseen. This is due to the fact that such events occur randomly. Statistical inference allows testing some hypothesis about data with random properties – like e.g. the apocalypse will be on the 21th December 2012 (null hypothesis). But even when the data fulfills all criteria for doing inference, it never tells us if it is a valid sample of the object of interest or not.
If we use for example a 95% confidence interval, we always face the risk of getting inaccurate results on 5% of all samples. And inaccurate simply means that the confidence interval does not cover the true parameter. Hence, even when the searched value is in between the calculated level C confidence interval, we do not know the exact value of the searched parameter. This is, using random data, impossible.
In a nutshell, there might be an apocalypse one day. But the due date will not be the 21th December 2012. There is a higher probability that you win millions with gambling in the casino – and you may be one of the lucky guys who know that the probability of such an event is very low. But actually, this is not the issue you should be concerned about yet.
The important fact (and maybe also the necessary information to earn significant trading profits on that day) is that millions of people know that the Maya calendar predicts the apocalypse on the 21th December 2012. Most people do not believe that the world will end on this date – me neither. But with certainty, this information is deeply fixed in the brains of many people and if there is a small quake, they may panic, no matter how rational they are.
What if the apocalypse predicted by the Maya calendar concerns in fact the financial market and not the world?
On the currency market, there are different groups of interacting traders, namely short-, medium and long-term traders (heterogeneous market hypothesis). Additionally, they are located on different places on earth, trading at different times and following different strategies. On a normal day these different groups interact with each other, generating a more or less random fluctuation of prices (assuming efficient markets). But do you think that the majority of traders will sit on a losing position the 21th December 2012 when there is an unusual market movement?
2. Price avalanches on the currency market
As next I provide you some information, which substantiates the hypothesis that on the 21th December, there may occur unforeseen price avalanches. Have you known that even a small price spike may trigger a price cascade? Richard Olsen, founder and CEO of Olsen Ltd. and visiting professor at the university of Essex, describes in his readable booklet ‘How to Trade’ that already small market orders can have a big price impact. Spreads, i.e. the difference between bid and ask prices, and profit opportunities of the market maker accordingly, are – compared with the average daily price movement of currencies (e.g. 0.6% for EURUSD) – very low (approximately 0.006% for EURUSD). In general, it holds that the more liquid a currency the lower its spread. Market makers thus face a high risk of incurring a large loss if they cannot sell their inventory of a highly traded currency. Even a small imbalance between demand and supply can provide a large exposure, where the market maker risks suffering a significant loss. Consequentially, he needs to aggressively adapt his prices to minimize his exposure risk.
It is sufficiently to trade about 200 Mio USD to move the EURUSD approximately 0.2%.
Under certain circumstances a price spike can lead to cascading margin calls, forcing some traders to close their positions. Due to the impending imbalance between buyers and sellers, market makers may be obliged to adjust their prices, triggering a price jump where additional margin calls become due. This process – let it call a ‘subsequent impulse-reaction process’ – can induce long-term trends and in the worst case, it may provoke market crashes.
The increased alertness of traders caused by the freely available information about a probable apocalypse – may it be conscious or not – is likely to enforce such a process; the probability of cascading margin calls rises when some factors seem to favor a specific direction.
Well, you may bring forward the argument that today approximately 50 to 70 % of all trades are done by automated trading systems. And these systems are certainly not programmed with a special algorithm that accounts for special events like e.g. a predicted apocalypse. But be aware of the problem, that when it gets critical, humans are likely to intervene automated trading machines. Already a minor number of wealthy traders can make the difference and carry other traders along with them, causing a significant price cascade. Additionally, trading algorithms may be coded such that they close positions if the market environment becomes critical. This may trigger – comparable with a margin call – an imbalance between demand and supply, where market makers need to interact, inducting a ‘subsequent impulse-reaction process’.
3. An apocalyptic scenario
There exist many theories about secret places on earth, which remain safe on an apocalypse scenario. The same holds true for currencies. Imagine the worst case, where all people panic and the financial market drops significantly. Save heaven?
Swiss francs; probably.
But what happens if there is a herding movement (like described above) and the demand for Swiss francs explodes? The Swiss national bank may not be able to hold the threshold at 1.20 Swiss francs compared to the EURO. Consequentially, the value of the EURO drops significantly, implying huge losses and significant consequences for at least European countries.
4. Closing words
In general, currency returns follow a more or less random walk and are very difficult to predict. There is a lot of speculative trading on the financial market. Especially for currencies, there is a large number of speculators driving the trajectory of prices. But there is a small chance that the 21th December will be one day with deterministic properties. So don’t waste this opportunity. Observe the market wakefully on that date. And don’t forget at least to hedge your position.