CBOE Brexit 50 - A Useful Guide To How To Make Money Out Of Brexit

Includes: FXB, FXE
by: Tim Worstall

The major determinant of the short term financial markets in the UK is Brexit - whether, when and how.

The effect upon listed equities will differ dependent upon their reliance upon domestic or foreign revenues.

There's thus a way to bet either way on Brexit, the CBOE Brexit 50s being an example of the idea.

The Basic Brexit Bet

Whether Britain is going to leave the European Union or not is still as yet unknown. If it does, when it does and how is going to be the immediate short term driver of the UK stock markets. However, and here's the thing, for some equities the effect will be positive, for others negative. Knowing which is which is which is thus useful. Which is where the CBOE Brexit 50 indices come in useful.

The Brexit Effect

As I've been pointing out here at Seeking Alpha for some years now, Brexit or not is the major determinant of the short term move of the British markets. As I've also been pointing out, the vast majority of the revenues - and thus profits - of the FTSE100 companies come from outside the UK, in non-sterling currencies. The harsher the terms of Brexit the higher such equities should rise therefore.

Ah, No, Let's Do Some Economics.

So, Britain leaving the European Union without a free trade deal will mean a deterioration in the terms of trade being faced. Having to face WTO terms on export tariffs will rather do that. So, what do we expect to happen? The currency will fall in value. This just is what happens when a free floating currency meets a change in the terms of trade. The balance of payments, by definition, balances and that's achieved by the currency changing in value.

So, firms that gain the majority of their revenues in non-sterling, but do their accounting in sterling, will see the sterling value of their foreign profits rise upon Brexit. And the harsher Brexit is the more this will be true. It's also true that since so little of their revenues stem from domestic British business then any Brexit induced slowdown domestically won't concern them.

On the other hand, despite the majority of the FTSE100, that's not true of all constituents. Some are domestically based, having near no overseas business. The effects there will of course be the opposite. They'll be hit by any domestic downturn but not by any currency effect upon foreign profits.

We'd thus like to be able to differentiate here between those who will benefit and those who won't.

CBOE Brexit 50 Indices

Fortunately the CBOE folks have done the work for us. They've examined the accounts of each and every FTSE100 constituent and told us how subject they are to Brexit effects. There's the High 50 and the Low. The definitions are here. The "Low" is those who have low dependence upon domestic revenues. Thus we'd expect their prices to rise, relatively, the closer or more harsh Brexit looks like being:

CBOE Low 50 (CBOE Brexit Low 50 Index - from CBOE)

Fortunately we can see that this does in fact work. As Brexit has been getting closer, as we seem to get closer to a no deal exit, then this index has risen.

The High is those with a high domestic dependence:

cboe high 50 (CBOE Brexit High 50 Index - from CBOE)

As we can see that's also performing as we would expect, falling as the harsher supposed terms of Brexit appear to become closer.

The Background Lesson Here

Well, one is I just get to say I told you so. Years back I said the markets would be, in their short term movements, driven by Brexit hopes. And that the resultant currency movements would impact upon equity prices. We've not some elegant information from these indices saying I was right. Whoop, Whoop, obviously.

But of course we want to know what to do next? Well, obviously enough, the same trade is going to carry on. The harsher Brexit terms look, the more likely it looks, the higher those components of the Brexit Low 50 are going to go, the lower the members of the High index are.

Unfortunately, there's no way to trade these indices directly, they're not the foundations of a contract anywhere.

So, What Do We Do?

Well, probably the best thing is to take the lessons of the research and to then try trading a proxy. Traded options will be available on all components. The topmost members of the Low 50 will be those most affected on the upside by a harsh Brexit, the tailenders of the High 50 will be those most depressed by that same hard Brexit. We could therefore simply play with a couple of traded options and thereby usefully mimic the effects of the indices.

My own opinion is that Brexit is going to happen by or on Oct 31. I am biased, I used to work for Nigel Farage, but then we might also say that I know something about the subject. It's also becoming increasingly likely that it's going to be a hard Brexit, on the most minimal or even no trade terms with the EU. Sterling's thus going to fall again and a useful bet would be put options on some of the Brexit High 50, calls on some of the Brexit Low.

This would, of course, be betting, not investing. Perhaps closer to the time, out of the money puts and calls, bought to cover the end Oct period, picked up for pennies as that bet. The advantage here being that the options are easily available, there's no need to risk all with futures.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.