Hedging Currency Risk: 4 Options for the Plummeting Dollar
December 20, 2004
With the United States Dollar hitting all time lows against the Euro Currency and 3-5 year lows against nearly all of the major foreign currencies, dollar denominated trading system and CTA investors are wondering just what they can do?
The Euro hit an all time high of nearly 1.35 Euros / US $ in the first week of December, and after a brief dollar rally last week, is back to within striking distance of new all time highs. The Euro has gained approximately 8% against the dollar this year after increasing over 21% in 2003. Elsewhere, the Aussie dollar has increased close to 50% over the past two years, and the Sterling, or British Pound, close to 30%. Foreign trading system investors with accounts in US Dollars have seen the value of their Dollars decrease substantially this past year - and its time they took notice.
The bear market for the US Dollar could continue for quite some time given the record levels of debt the United States keeps issuing to finance its ever-widening account deficit. In the simplest terms, the United States government spends much more money than it takes in - by hundreds of billions of dollars - and must borrow money through issuing T-Bills and other government bonds. The more money the US borrows, the amount of money needed to cover those loans increases, and therefore the supply of dollars increases. As in any commodity, the more supply you have, the lower the demand and therefore the lower the price.
Added to this basic economic perspective is the feeling that a weaker US dollar could help erase the deficit that has caused it, putting even more downward pressure on the US Dollar. The logic behind a weak dollar helping reduce the deficit goes something like this: the weaker the dollar, the cheaper US good are, and therefore the more US goods US citizens and the rest of the world buys, and therefore the US has more money than it spends, meaning it doesn't have to borrow as much. The relatively weak stance by the Bush administration regarding the dollar has signaled to many currency traders that a weak dollar is part of the administration's plan to cut the deficit.
Most investors shrug this off as insignificant to their portfolios, but the effect for foreign investors can be severe. To truly grasp what we are talking about here, imagine an investor who opened an account in US Dollars in January of 2003. This investor would have had to convert about 98,000 Euros into $100,000 Dollars. If this investor had exactly $100,000 Dollars left in the account today, and wished to convert her Dollars back into Euros, she would have only about $75,000 Euros left. Without doing a thing, this investor would have lost $23,000 Euros. This loss would be on top of any potential losses or gains a specific alternative investment our fictional investor is weighing - and must be considered as a hurdle rate or break-even point for such an investment.
The crux of the problem is that most investments worth making are in US $. This is especially true in commodity futures, and even more so in trading system and CTA investments, which are invariably run on US $ denominated derivatives. The grand majority of futures markets are traded on US exchanges such as the Chicago Board of Trade and Chicago Mercantile Exchange. So what is an investor to do?
At Attain Capital, where a large portion of our clients are outside of the US, sophisticated investors have been implementing several techniques to guard against further moves in the Euro and other foreign currencies.
Hedging Currency Risk Within your Portfolio. 4 Options:
1. The cash balance of your account can be held in the foreign investor's native currency, converting to dollars when needed to cover closed trades. The cash balance of the account would remain in the designated foreign currency, Euros for example, but if a trade was done in the S&P futures, for instance, resulting in a loss of $2,000 US Dollars, the amount of Euros needed to convert to $2,000 US Dollars at the current exchange rate would be converted. This method keeps the account in unison with the current exchange rate.
2. Investors can buy outright futures contracts on their native currency, gaining or losing the appropriate amount of money as the contract moves up or down. After all, this is what futures markets are designed to do. The problem inherent in that is you are locking in the current rate, as the account grows as your dollars become less valuable and shrinks as your dollars become more valuable. Many investors are leery of locking in such high rates. In addition, with no fractional contracts available, the investor must hedge as closely as possible with an appropriate round number of contracts. If having to round down to less than a perfect hedge, this would mean hedging profits less than those needed to offset rate losses, and if having to round up to more than a perfect hedge, this would possible hedging losses not equal to rate gains. This method attempts to lock in a specific exchange rate.
3. Investors can sell puts below or at the current market price. You will keep the premium if the foreign currency goes higher, but this premium won't completely offset the loss in value of your dollars. If Euros, for example, head lower, you will be exercised on your option, taking a long position at the strike price. (essentially locking in a lower exchange rate than in option 2) The benefit of this is you lock in a lower rate, and you keep the premium. The risk is that your currency heads higher and you only offset some of the losses. This method attempts to lock in a lower exchange rate.
4. You can overweight your native currency in your current trading, going long extra contracts when long term systems such as Dollar Trader or Aberration gives a long signal, and not taking the short contracts, as you are in essence already making money on the short side because of the conversion. This method attempts to "play" the exchange rate, locking in rates before it moves higher, and putting money back at risk when rates move lower.
Attain Capital suggests different approaches depending on the situation. For those investors opening new accounts, Option 1 may make the most sense if they believe their native currency will continue to outpace the US Dollar.
For those investors currently holding accounts in US Dollars, Attain Capital recommends a combination of Options 3 & 4. Trading systems are built to capture moves in such commodities, after all, and using a system for this purpose logically fits. Passing on short signals from a trading system in your native currency also makes sense, as holding your account in US Dollars gives you a synthetic short position already. Adding a short position from a system greatly increases the currency risk a US Dollar based investor has already taken on.
The table below shows similar bullish moves in the Euro Currency, Japanese Yen, British Sterling, and Aussie Dollar have occurred over the past year, making this article valuable for anyone outside of the United States. The methods outlined above hold true in the other currencies as well.
Please call Attain Capital at (800) 311-1145 or email currencyhedge@attaincapital.com for a review of your currency exposure risk and what options may be available to you.
- Jeff Malec
IMPORTANT RISK DISCLOSURE
Futures based investments are often complex and can
carry the risk of substantial losses. They are intended for sophisticated investors and are not suitable for
everyone. The ability to withstand losses and to adhere to a particular trading program in spite of trading
losses are material points which can adversely affect investor returns.
Feature | Week In Review | Chart of the Week |
Feature | Week In Review | Chart of the Week |
After the US dollar staged a brief rally two weeks ago, last week saw the dollar resume its downward trend - much to the relief of trend followers. The topic of the week below discusses four options for hedging against the bear market in the US Dollar.
Trend following systems were happy to see the dollar continue down, however, as the majority of long term systems remain in long foreign currency (short dollar) positions.
Elsewhere, US stock indices were rather slow and left little room for intraday profits as the holiday trading environment (low volume and low volatility)seemed to surface last week despite a quadruple witching day on Friday.
**Day Trading**
As mentioned above, it was a relatively difficult week for day trading systems; with just two systems showing profits for the week.
Both profitable systems last week came from the Mariner Futures stable, with Compass continuing a strong month by posting $1,247.50 in profits last week, while Clipper eRL posted $192.50 in profits per e-mini Russell.
There was little else to write home about in the day trading realm. Blue Wave Zones SP took a break from an otherwise strong month in losing -$1,237.50, while R-Mesa SP did likewise - losing -$1,450 last week to stay just a tick above even for the month.
Elsewhere was more of the same, with Founder Trading's Helix losing -$1,715 for the week, and their e-mini systems Cipher ES and Magnitude ES losing -$412.50 and -$420 respectively. The RC systems continued to struggle, with RC Miracles SP losing -$1,725 and RC Success ES losing -$265 per emini, while Daybreaker SP lost -$1,325, AG Xtreme SP lost -$2,275.
**Swing Trading**
There was not much swing trading action for the week, as many swing trading systems remain down for the month. I-Master had one trade, getting stopped out of the Mid Cap for a loss of -$1,990 per emini Mid Cap. I-Master remained short the ES, NQ, and eRL meanwhile.
Tzar had the best week out of all the swing traders after reversing short in the e-mini Russell for profits of +$2097.00 per contract. The system, which has struggled lately, remains long in the ES and NQ markets as well.
Axiom was active in the ES, e-RL, and e-MD markets. The system posted a loss of -$247.50 in the e-mini SP, however it has established strong long positions in the e-mini Russell and e-mini Midcap markets.
Eclipse e-RL continued to impress in it's second week of trading at Attain posting gains of +$425.00 per contract in the e-mini Russell market.
**Long Term**
The long term trend followers were quiet throughout the week as many of the commodity markets remain choppy. Andromeda was the most active system entering long in the US bonds and getting stopped out of a a short trade in the unleaded gas. The system was enticed by the Fed's apparent lack of fear of inflation, which sent the bond markets soaring. The unleaded gas trade, while volatile, was profitable making +$160.00 per contract.
Synergy had the trade of the week, exiting a long Japanese Yen trade for profits of +$2568.75 per contract. While the system has been holding long for nearly three months, it was able to lock in the majority of it's gains despite the recent pullback in the currencies.
Trendchannel was the only other trend follower to trade, going long in the Eurocurrency on the heals of the Fed meeting this week.
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IMPORTANT RISK DISCLOSURE
Futures based investments are often complex and can
carry the risk of substantial losses. They are intended for sophisticated investors and are not suitable for
everyone. The ability to withstand losses and to adhere to a particular trading program in spite of trading
losses are material points which can adversely affect investor returns.