Swiss Bank to Traders: Here's Some Hot Cocoa in Your Face

The Swiss central bank  sucker punched the financial community by unlinking the Swiss franc from the euro. As a result, those who trade in currency markets saw huge gains or losses. And while some blamed the bank’s move for the ensuing market volatility, both U.S. and international stocks gained that day.

But there are some very important lessons to take from last week’s events, and those lessons are best learned before fortunes are lost.

Foreign currency futures are contracts that allow you to buy a currency for a certain price at a set date in the future. If you bet right, you can make a pile, hence an appeal that can be nearly irresistible. Yet as Jason Zweig noted in last Saturday’s edition of the Wall Street Journal, roughly two-thirds of individual foreign exchange traders lose money!

Though you may wonder whether this dismal record is due to bad luck or poor skills, the answer is neither — it’s the game itself. In the history of the futures market, not a penny has ever been made in the aggregate. And that’s before fees.

As it happens, if someone bets on the Swiss franc, someone else has to bet against it. In the aggregate, the two will net zero — again, before fees. This is no different from a bet on the Super Bowl. Will Seattle repeat last year’s triumph, or will New England take the title? I don’t know, but I’m sure not going to bet my financial future on it. Doing the same with foreign currency futures is similar to betting on any sports event through a bookie, who takes a large cut from your bet.

Why do futures markets exist?

Foreign currency futures do serve an important role in financial markets. If, for example, a U.S. corporation wanted more predictable earnings (valued by Wall Street), and a large portion of its sales came from Europe, it could buy euro futures contracts; essentially, these are insurance against foreign currency exchange-rate volatility. This foreign exchange insurance provides value much in the same way that Southwest Airlines stabilizes its costs by buying jet fuel futures to smooth out wide swings in fuel prices.

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It’s important to remember the difference between investing and speculation. Investing involves taking a risk only when you expect a positive return. Speculation is taking a risk for no expected return or even an expected negative return. Betting on sports, buying a lottery ticket and buying foreign currency futures all fall squarely into the category of speculation. All of these can be fun, but none makes a particularly promising retirement plan.

Photo: scibak/iStock

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