The Brexit Hedge: A Once-In-A-Lifetime Trade
Rob Colville | Apr 18, 2016 04:54PM ET
It’s been said that “History waits for no one,” and that saying seems rather fitting right about now, when there’s upon us what many, myself included, are calling a trading opportunity for the ages. Currencies like the British pound (GBP), euro (EUR), and Swiss franc (CHF) are especially in play as a referendum is set for 23 June to decide whether the UK will remain a member of the European Union going forwards.
The potential departure of the UK, or “Brexit,” as it’s now popularly known, has given rise to plenty of volume and volatility, with GBP trending steadily lower as the calls in favor of a Brexit grow louder. Traders can expect volatility to escalate even more throughout the coming months, with preliminary polls and comments from the electorate and key stakeholders driving price action across a host of major currencies.
Rather simply, though, here are the current and impending scenarios, the major players, and what to watch for. And, most of all, here’s how traders may capitalize on the affected currencies in the lead-up to the 23 June referendum and beyond.
Why This Event Risk Is So Significant
The upcoming referendum is a monumental event risk for a host of world currencies, even those outside of Europe. The US dollar (USD) and Japanese yen (JPY), for example, would likely be among the main beneficiaries should a Brexit occur. And, regardless of the vote’s outcome, the strongest impact is being felt across the Eurozone, where potential changes to trade agreements, credit ratings, and even the rules and guidelines for EU membership could be called into question.
Clearly, the upcoming UK referendum may well begin an entirely new chapter for Eurozone economic affairs, which is, in large part, why it’s seen as such a monumental catalyst for forex traders. Recent technical price action in GBP confirms the significance, as seen on the below chart:
Notice the steep and sizable downtrend, with choppy price action prevailing of late, largely on the back of pro- and anti-Brexit rhetoric from key officials. UK Prime Minister David Cameron is at the epicenter of the discussion, as the impending vote was part of Cameron’s 2015 re-election campaign promises.
Cameron, who would be in charge of brokering potential exit discussions, has also been working to publicize the possible negative economic implications of an actual exit vote. And while this event risk is one that’s all its own, the market-moving significance may be comparable to last year’s UK General election and the Scottish Referendum, each of which moved markets by more than 500 pips, and gave rise to a pair of highly successful trades: Long GBP/AUD and short FTSE, respectively.
Get The News You Want
The buildup and reaction to major news and changing policies always have the power to produce strong trend and/or trend reversals, and this is certainly no exception. With that, now is a time to plan accordingly and take swift action in hopes of getting out in front of strong and decisive moves, which could once again materialize on the back of this event risk.
What If the UK Really Does Vote to Leave the Union?
There has been no shortage of speculation on the subject, and especially as pro-Brexit comments and rhetoric has spurred sizable recent gains in EUR/GBP, Prime Minister Cameron and others have been quick to warn about some ominous possibilities.
If the UK does ultimately vote in favor of independence from the EU, GBP/CHF, for one, will likely crater lower, while EUR/GBP will spike higher. Those trades are essentially one in the same, since EUR and CHF are highly correlated. As a result, we advise exposure to only one, and not both pairs.
Conversely, if the vote returns in favor of the UK remaining a member of the EU, GBP/CHF will likely rally, and EUR/GPB will likely retrace lower, presenting the possibility for high-probability trend reversal trades like this one, taken in early December at the start of the move.
A critical point about the referendum, however, is this: Price action across a number of key currencies is not all that’s at stake here. As mentioned earlier, trade agreements, credit ratings, debt repayments, investments, and the very fabric of the EU’s membership structure, could come under fire if the UK elects to leave the Union, and possibly even if it does not.
Prime Minister Cameron has warned about potential fallout, as have other EU officials, but the strongest warning to date may have come from ratings agency Standard & Poor’s:
”In a worst-case scenario, a Brexit could also harm the sterling’s role as a global reserve currency, removing what has been a significant support for our AAA rating on the UK since the start of the global financial crisis.”
-Standard & Poor’s Statement
So there you have it: The GBP’s status as a reserve currency, and the UK’s AAA credit rating could be at stake as well, not to mention the fact that as much as half of all UK trade and investment comes from its Eurozone partners.
Bringing all these factors together could mean huge downward moves for GBP/USD, GBP/CHF, and perhaps GBP/JPY, plus a corresponding upward move for EUR/GBP. So as these currencies and others are already reacting in advance of the referendum, let’s now turn our attention toward how to profit as traders…
Trading the Lead-up to the UK Referendum
In devising a trading plan for going forward, it often pays first to consider where and how this opportunity essentially began. As shown earlier, the downside reversal in GBP/CHF that began on 1 December 2015 originated with a pin bar reversal pattern seen at a lower high near multi-year resistance. And while most any reversal trade like this one is low probability in nature, the much higher reward potential can make them worthwhile with an entry signal as strong as this one.
We followed a standard entry methodology, using the bearish pin bar reversal as a signal and guide, and placing in this case a sell entry at the low of the day, minus spread, minus an additional pip. The stop was placed above the daily high, plus spread, plus an additional pip, and we were triggered into this trade in relatively short order, which was a precursor for many good things to come!
As it turned out, this was the beginning of the move to the downside that’s continuing to the present day, and that could continue or even accelerate on the back of pro-Brexit momentum, and especially in the event that the UK votes in favor of independence on 23 June.
Since the initial reversal trade on 1 December, higher-probability trend opportunities have arisen on two separate occasions, and we’ve used the retracements in question to add to our initial position.
Gains like these—in excess of 30% while risking no more than 1%-2% of total account capital—are like a dream for traders, and because they don’t come around often, it’s clear that this is a special trading opportunity many simply shouldn’t pass up.
Traders may now be well-advised to carry forward until the verdict and continue to sell rallies in the overall downtrend in GBP/CHF on either the daily or weekly time frame. Be advised, however, that the weekly chart of GBP/CHF shows a massive range which is approaching the midpoint.
Recognize also, that a vote in favor of staying in the EU would likely send the trade in the other direction, so it will be necessary to trail your stop rather closely behind in order to preserve and protect hard-earned gains from prior short positions.
Until the verdict, though, we will continue to look for any opportunities to sell rallies in this downward- trending market. As news and rhetoric continues to drive price action in a number of key currency pairs, traders may expect plenty of volatility, and should look for further chances to capitalize on high-probability trend set-ups in pairs like GBP/CHF, EUR/GBP, and perhaps others.
Until then, trade well.
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