3 Ways to Play the Dollar's Next Move
Wednesday, October 28, 2009 | Teeka Tiwari
As you learn about tapping into the wealthy world of currencies (see Part 1 and Part 2 of our ongoing series on profiting with currencies), be cautious about jumping on the short-sale U.S. dollar bandwagon.
This is a trade that is getting a little long in the tooth and, at the very least, is due for some action to shake out some of the weaker bear hands.
What's Next for the Battered Buck?
Shorting the dollar has been a great play since stocks bottomed in March. And longer term -- if we do not get our deficit spending under control -- then the U.S. dollar looks to go lower.
However, over the short term, the dollar is very sensitive to movements in the stock market. Should we get even a relatively mild pullback in the major equity indexes, then the U.S. dollar will almost certainly rally as hot money looks for a safe and secure place to park itself.
A Diversified Dollar Play
One of the most widely watched and traded benchmarks of U.S. dollar strength/weakness is the U.S. Dollar Index (Symbol: DXY).
This index tracks the value of the U.S. dollar against a basket of six major currencies. Those currencies are the Euro, Japanese yen, Canadian dollar, British pound, Swedish krona and Swiss franc.
The index was created in 1973 with a base value of $100. So, the U.S. Dollar Index having a current value of 76 tells us that dollar has declined 24% against the basket of currencies in the U.S. Dollar Index.
Futures traders use the DXY as a way to either get long or short the dollar. Because the DXY is priced against a basket of currencies instead of just one currency, it's a more-diversified way of playing movements in the U.S. dollar.
Here's how that works:
- When traders short the DXY, they are in effect selling U.S. dollars and going long the six currencies in the index.
- When traders buy the DXY, they are effectively shorting the six currencies in the index and buying the U.S. dollar.
A More-Targeted Way to Play
Traders who are looking for a more-targeted way to trade the dollar will trade "currency pairs."
A currency pair gives you the ability to go long or short the dollar against a specific currency -- i.e., short the dollar, long the Euro ... or long the dollar, short the Japanese yen, etc.
Pairs-trading is important because not all currencies will decline or appreciate against the dollar evenly.
Over a six-month period, the Euro might increase in value by 15% over the dollar, while the yen may only appreciate 7% over the dollar during the same time period.
Currency pairs give traders more flexibility in honing in on those currency relationships that they feel have the most upside. Remember, all currency trading is relative. The whole game comes down to betting that one currency will go down (or up) relative to another currency.
Pick Your Pairing
In other words, you can trade any pairing that you choose, in which you're betting that one will go up while the other will drop. That's the "exchange" in "foreign exchange" (or, forex).
For example, the USD/CAD currency pair enables you to go long the U.S. dollar while simultaneously shorting the Canadian dollar against it. This pairing is otherwise known as the "Dollar-Canada" or, less formally, the "Loonie."
There are many other pairings with the dollar, and others that do not involve the dollar (those are called cross-currency pairs).
Yet Another Way to Trade Currencies
While more and more individuals are learning how to trade currencies, many individual investors still find this type of trading (i.e., futures trading) to be very intimidating. The good news is that there are now many currency Exchange-Traded Funds (ETFs) available.
These ETFs mimic the underlying currency or currency index ... without the risk normally associated with direct futures trading.
PowerShares has two ETFs based on the dollar. One allows you to profit if you believe the U.S. Dollar Index will rise, and the other allows you to profit if you feel the U.S. Dollar Index is going to go down.
The Bullish U.S. Dollar Fund (Symbol: UUP) and the Bearish Dollar Fund (Symbol: UDN) were created to mimic the underlying index.
However, as a note of caution -- due to transaction costs and price differences between contract rolls -- currency ETFs will typically underperform the index that they are tracking.
From what I've seen, though, this underperformance isn't as egregious as we've seen in the oil ETFs, but it is present and you should be aware of it.
Investing Tools for Currency Traders
So there you have it -- you can bet on the direction of the dollar with currency pairs, the Dollar Index, and two currency ETFs based on the Dollar Index.
Even though currency trades are often very short term in nature, as an investor you may find it easier to join the forex trading game with instruments (i.e., indexes and ETFs) that are more familiar and readily accessible.
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Teeka Tiwari
Chief Investment Officer
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