Trading the Brexit vote

And so the big day is finally here.  After months of waiting, steadily rising anticipation, and not a few awkward moments, we'll see an important watershed reached today.   Here at Macro Man Towers, where Mrs. Macro hails from the north of England, the house is all aflutter.   Yup, Macro Boy the Younger turns 13 today, officially becoming a teenager.

Oh, you thought Macro Man was referring to something else?  He almost forgot- there's that little matter of the Brexit referendum today (and early tomorrow) that seems to have captured the market's fancy.  At the time of writing (20:00 NY time), the latest polls have tilted further towards Remain and confidence appears to be growing that Brexit will vanish stage right.  There remains considerable uncertainty, however; the margin remains very close, and vol remains elevated.  (The implied overnight cable vol as of about 16.00 NY time was 120...or 5% in the straddle.)

Anecdotally, it doesn't sound a if speculative participation in the currency market amongst professional investors is very high at all.  Given the magnitude of the event, that may seem shocking, but if you think about it it's not very surprising at all.  Perhaps the only consensus view surrounding the whole bloody mess is that market liquidity is going to be abysmal and that it will be very difficult to transact size, particularly if the vote is close.

If you go into the referendum with a position, you have become a price taker.  In other words, you're going to rely on the market to let you out of your position, either on a take profit or stop loss basis.   If you need to shift any kind of size, this is going to be very problematic, particularly given the possibility of wide gaps (the market is using post-SNB CHF trading as a model here.)  Lest we forget, these results are going to be coming in during Asian trading hours...8.00 am London it's not.   Being a price taker, therefore, puts you at a decided disadvantage.

Let's consider a stylized model of how the market will trade.    We'll assume that there are two data points: an initial reading relatively early on in the proceedings, and then a final result.  Each of these can point to either Remain or Leave, which gives us 4 possible combinations:  RR, LL, RL, LR.  The problem is that no matter whether you are long or short cable, three of the four possible outcomes will leave you with a mark to market loss at some point during the day.   The table below sketches out the cable P/L (expressed in big figures, not percentages) based on the assumption that a) cable moves in line with the coefficients calculated in Macro Man's model, and b) that the initial result will push the Leave odds halfway towards the binary final outcome (0 or 100) from the current 20% or so.

So if 3/4 of the world states will leave you with a mark top market loss at some point, AND price action will be slippy and nasty (in case you want to cut and run), where's the edge?  There isn't one.

Rather, in a market that is suffering from a deficit of liquidity, the edge will come in providing liquidity AFTER gappy moves.     Even this will be easier said than done, of course, but leaving modest limit orders at levels where you think the outcome is fully priced (1.25 and 1.53?)  won't get you into too much trouble (they may well go unfilled) yet could land a nice windfall profit.

While the last published odds that Macro Man has seen put Leave at 22%, given the move in sterling since the latest polls came out it looks more like 20% from his perch.

Macro Man also tried to regress the FTSE based on the the odds for Leave,  but perhaps unsurprisingly the relationship was much weaker than with sterling.   FWIW, the regression put each percentage point of Leave odds as worth 7.75 FTSE points; given where the odds were when the FTSE closed today, that would leave a Remain vote as being worth 3% on the index.   While that feels a little low, it's probably close to the right ballpark; over the last year, there have only been six days with moves of that magnitude in either direction.  A Leave vote, on the other hand, would imply a downdraft of a little more than 9%.

Most readers will by now be aware of the niceties regarding reporting times by district, early turnout levels, the weather, etc.   Suffice to say that information is likely to drip out  from just before midnight in the UK until breakfast time tomorrow, with turnout figures published before voting results.   Punters and pundits will key on turnout figures from UKIP-friendly districts as well as those (such as London) more well-disposed to remain.

Having spilled so much (virtual) ink on the subject recently, Macro Man reckons he'll stop here.  While it would be fun to do a live blog of the day, he has birthday commitments with MB the Younger today.   Good luck, and try to have fun!