Hedging Currency Risk: 4 Options for the Plummeting Dollar
December 18, 2006
With the United States Dollar hitting multi- year lows against the British Pound, Australian Dollar, and Japanese Yen this month, and threatening such levels against the Euro Currency, dollar denominated trading system and CTA investors are wondering just what they can do?
After a dollar rally throughout much of 2005 and some of 2006, it looked like the doomsday prophecies of the US Dollar tanking against the major currencies of the world was not going to come to fruition. But 2006 has seen a 6% rally in the Aussie Dollar versus the US Dollar, a 10% rally in the Euro versus the US dollar, and a 13% rally in the British Pound Sterling versus the US Dollar to put the Dollar decline right back in the forefront. 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.
And finally - Venezuelan leader Hugo Chavez is urging other Oil producing nations to follow his lead in directing a growing share of oil profits into Euros as the dollar and crude prices fall. That could mean billions of dollars a year not buying dollar denominated assets, further lessening demand and prices.
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 Australian investor who opened an account in US Dollars in January of 2003. This investor would have had to convert about 178,000 Australian Dollars into $100,000 Dollars at that time. If this investor had exactly $100,000 Dollars left in the account today, and wished to convert her Dollars back into Aussie Dollars, she would have only about $128,000 Aussie Dollars left. Without doing a thing, this investor would have lost $50,000 Aussie Dollars. 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.
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 |
***Overview***
The US Stock market continued its push to the upside last week. Once again favorable inflation reports are helping stimulate the stock market to record levels, mostly because traders believe the Fed will not raise interest rates as long as inflation appears to be in check. Regardless of your stance on the state of the economy, it is hard to argue with those who have bought stocks and held on to them throughout the past year as the stock market can seemingly do no wrong. Last week NASDAQ futures led the charge gaining +1.19% while SP futures were up +1.13% for the week. In small cap trading both Russell 2000 futures and SP Midcap futures held steady and were unchanged for the week.
In currency trading the US dollar gained a little of what it lost over the previous two weeks with US Dollar Index futures gaining +0.92%, while Eurocurrency futures lost -0.92%, Swiss Franc futures lost -1.47%, and Japanese Yen futures were down -1.49% for the week. US Treasury futures also pulled back last week with 30 year bond futures falling -0.55%.
Energies rallied higher after another round of promised production cuts from OPEC next spring. Crude Oil futures moved +1.46% higher on the news while RBOB Gas futures rallied +3.50% higher, and Heating Oil gained +1.19%. However, the comments had no effect on the Natural Gas market which moved -2.32% lower last week.
Metals were also very actively traded last week as prices tumbled. Silver futures led the way losing -6.59%, while Copper futures fell -3.07%, and Gold dropped -1.89%. Palladium also moved lower losing -2.90%, although it’s sister metal Platinum remained unchanged for the week.
Other commodities in the news last week include Cotton which rallied +4.23% higher, Sugar was up +1.14%, and Wheat gained +1.75%. Finally, Lean Hogs prices were down -3.15%.
***CTAs***We would like to use this space to highlight one particular CTA this week. World Capital has been an emerging manager over the past 2.5 years and is rapidly approaching 3 full years of active management. Clients having worked with World since inception are enjoying the fruits of their labor by achieving annualized returns of +26.66% with a maximum drawdown of only -4.25% throughout the period. As a firm they have been rewarded for their work and are currently managing just over 25MM in client assets.
November was a particularly impressive month of trading for World as clients enjoyed returns of +4.4%. Noting that the strategy’s returns are tied to market volatility, one could generalize that World successfully capitalized on the short term increase in market volatility that occurred following the mid-term US election by initiating new December positions near mid month. World initiated several new February positions last week and is currently slightly ahead for the month.
***Day & Swing Trading***
The stock market rally continued last week with the major indices breaking new yearly highs. The downside to this strength in equities in that volatility continues to fall to new lows as measured by the VIX at the CBOE which hit a new multi-year low of 9.39 on Friday.
This lack of volatility made it difficult for all but the most aggressive day trading systems to make money last week. BWT Zones Classic and aggressive go hand in hand and that eagerness to enter trades prior to other programs paid off last week as the system went on to make +$2,875 on five trades. OPXP eRL was more selective in its trading but reached its profit objective on its sole trade from Tuesday for +$370. Compass SP finished the week with profits of +$325 on two trades-a winning long trade on Thursday followed by a smaller losing short trade on Friday.
Slowly we are starting to see some of the swing systems start to jump on the short side but a few are still holding on to long positions and reaping the benefits. Seasonal ST ES and eRL continue to hold long positions that were entered over a week ago and tacked on another +$800 and +$80 respectively in open trade profits. Tzar is long 3 of 4 domestic markets in the NQ, eRL and eMD but short the ES. Spartan ES is holding short and lost -$800 in open trade profits as the ES continued to move higher throughout the week. Adaptive US portfolio lost -$620 for the week on a single short trade in the eRL that was stopped out.
***Long Term***
Interest rate markets continued their correction for a second consecutive week, moving the trend more to the upside. Long term systems continue to have an upside bias with long positions held by Andromeda +$3,006.00 (open trade), Vivaldi +$1,353.50 (open trade), Pegasus -$240.25 (open trade) and Trend Simplicity exited its position -$646.88 in USZ. Axiom LT is Long TYZ with open trade equity of +$282.50 as is Pegasus with +$10.00 (open trade). Aberration is long TUZ with open trade equity of -$1,361.25.
Major foreign currencies posted another round of modest losses during the past week sparked by worries that euro zone interest rates remain relatively low and on ideas that economic data in the U.S. hasn’t really shown enough cooling to warrant interest rate cuts in the U.S. for the first quarter of 2007. General profit taking after the Euro rallied to highs not seen since June two weeks ago also remained a constant, especially with traders heading for the sidelines ahead of the holidays. U.S. economic reports this coming week could spark some more market interest, but the will having to be way out of line from estimates to get participants back into the game ahead of the New Year. Systems with short positions in DX include Axiom LT +$880.00 per contract (open trade), Aberration -$710.00 per contract (open trade) and Trend Simplicity +$760.00 (open trade) per contract. Systems long EC are Trend Simplicity with an open trade profit +$3,012.50, and Vivaldi -$225.00 (open trade). Andromeda excited long EC last week with a -$175.00 loss.
The energy sector continues to stay fixed in the sideways range it has maintained since October. Most long term systems banked their current short positions in crude during the past few weeks with Pegasus making $+14,160.00 per contract, Trend Simplicity making +$14,100.00. Vivaldi exited its short mini crude position making $+487.50 (open trade).
Grains and Oilseeds remained in a sideways to lower holiday mode last week as pressure entered the sector from weaker cash basis levels on ideas that the export markets will lose some luster heading into the holiday. The markets also succumbed to ideas that recent gains could spark heavy planting world wide in the year to come not to mention that current world stocks remain quite plentiful heading into the South American growing season, which as of now has been good. Systems with long corn positions include Aberration making +$3,175.00 (open trade), Andromeda +$2,487.50 (open trade), Axiom LT +$4,112.50 (open trade). Vivaldi exited Short Soybeans last week making +$1,225.00. Systems with short cotton positions are Axiom LT +$5,310.00 (open trade) and Vivaldi +$2,415.00 (open trade).
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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.