Grab a Big Mac and Hit the Road to Parityville
by Karim Rahemtulla, Advisory Panelist
Wednesday, June 2, 2010: Issue #1272
“I followed your advice and bought the CurrencyShares Euro Trust (NYSE: FXE) $130 January 2011 put for $4.30. As of today, I’m up 141%. Thanks for a good call!”
– Darryl
“Karim, I purchased the FXE [LEAP put options] at $6.80. Since the value has doubled, I was wondering if you would go ahead and sell at this point?”
– Mark B
Just two e-mails from readers that I received last week, in response to my article on how to play the euro’s 10% decline to bag a 100% gain.
Good stuff, guys – congratulations. Proof that it’s possible to take big gains, even in a volatile climate. And a 141% return is pretty sweet in any market.
I don’t say this to brag. I want to publicly address Mark’s question about whether to sell FXE at this point, since securities laws don’t allow us to give one-on-one investment advice to our readers.
So here’s what to do…
When Your Investment Hits Triple Digits, it’s Time to Hitch a Free Ride
My advice for anyone who is up by 100% or more is quite simple: Use the partial profit taking strategy by selling enough to take your capital off the table and ride the rest free.
That goes for pretty much any investment, not just an options play on FXE.
So in this case, while we still have plenty of time left to make money (because I advocated using LEAP options), remember that options do lose value every day. So it would be wise to sell half and then institute a trailing stop on the remainder to protect your gains.
And as for the euro?
Next Stop: $1
Anyone who thinks the worst is over for Europe – and the euro – is living in Fantasy Land.
The Eurozone is in deep trouble and the current spate of bad news is only the beginning. In the near term, there’s no end in sight.
The euro has no choice but to fall much further – probably down to the $1 level and maybe below. In fact, it may even test $0.90 – a level it touched briefly at the turn of the century, just a short time after the currency was introduced. That level is unlikely, but not improbable.
That doesn’t mean there won’t be pockets of strength now and again. But the underlying trend is in place. And the solution being secretly espoused by the Eurozone’s bigger export-driven nations (notably Germany) is a dramatic one.
Few things can kick-start an economy faster than a devalued currency – as long as it happens gradually, that is.
Of course, one might argue that a 12% fall in six months is a collapse. But from an investment point of view, the euro has fallen, not collapsed. The currency is still just experiencing a sharp correction, albeit within a bear market that began exactly two years ago when the euro hit lofty levels of $1.60.
And the reality is that the euro has been aching for a fall for quite some time.
So how do you determine value? While most investors look to daily currency rates, I believe there’s another determining factor that holds greater historical sway…
It’s All About Big Macs and Purchasing Power Parity
That factor is “Purchasing Power Parity.”
Simply put, this reflects what a currency can buy in its local market, versus the same products in other currencies’ markets.
A widely used measure for this is the Big Mac Index.
Big Mac Index The Big Mac Index is a survey by The Economist, which measures purchasing power parity in about 120 countries. Its yardstick is the price of a McDonald’s Big Mac in those respective countries in order to see how far a dollar stretches from place to place. For example, how much does a Big Mac cost in the United States, compared to what it costs in Britain, France, Japan, etc. Also known as “burgernomics,” the idea is that a dollar should be able to buy you as much in other countries as it does in America for the same goods and services. The Big Mac Index might seem simplistic to many, but it’s this gauge of purchasing power that truly reflects the on-the-ground value of a currency. Think of it as a kind of “exchange rate,” which can tell you whether a currency is expensive or cheap. |
By my count, a Big Mac still cost less than $3.50 in the United States, while the very same burger costs almost $5 in places like France.
Granted, there are other factors involved, such as taxes and transportation costs, which vary from country to country. But at the end of the day, a can of Coke is a can of Coke. And unless you’re trying to buy one in the Gobi Desert, the price should be close to the same everywhere, in relation to income.
Take a look at The Economist’s Big Mac Index, however, and you’ll see that this isn’t the case.
To see the original article from The Economist, click here.
As you can see, a Big Mac in the Eurozone costs about 30% to 40% more than in the United States. China is at the other side of the spectrum, selling Big Macs for under $2.
- In short, here’s the deal: The euro will remain under pressure for some time to come. According to the laws of supply and demand (and Big Macs), the odds are that as the massive supply of euros continues to hit the market, it will push the currency’s value down.
- The beneficiaries of this trend? European exporters, who sell their goods in euros. A weak euro makes their products cheaper abroad. This is where I would look to capitalize, as well as with some well-placed bets against the FXE, of course.
Good investing,
Karim Rahemtulla
Related Investment U Articles:
- The PIIGS Are Getting Sloppier… Here’s How to Clean Up
- These “PIIGS” Aren’t Flying… But Here’s An Investment That Will
- The Purchasing Power Portfolio: This Five-In-One Investment Is the Ultimate Way to Diversify
- I’m Hearing Bull From Dollar Bears
- Why You Probably Don’t Want to Hold Euros in 2011
3 Responses to “Grab a Big Mac and Hit the Road to Parityville”
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Dubbed a "market maven" by CNBC, Karim Rahemtulla is one of the country's foremost specialists in options trading. As founder and editor of The Smart Cap Alert, he focuses his efforts on all aspects of options trading – LEAPS, put selling/covered calls and spreads. 
Karim, thanks for answering my question. This is what I anticipated, but your confirmation helps. Mark B.
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I appreciate what you say in the article and I have, for a the last 2 years (since I’ve started to trade currencies), used the Big Mac index as a final sense check as to where things may be (really) out of kilter. (In fact after the last meltdown it was what I used to decide which positions to take profits on and which ones to ride for more profit).
Will it work in the long run? Who knows…but it is a benchmark nonetheless.
What’s my point???
Easy to get bearish on Euro/USD now when it is the trend, but who was bearish at 1.50 last fall? My bets at that point looked like a real sucker and I have to say I put smaller chips on the table rather than betting up as I had planned above 1.50 – but still they played out great nonetheless.
What’s my point?
The Big Mac index for the Eurozone aggregate is a joke. If you want to know what the real PPP EUR/USD rate should be, compare it in Euro DM’s. You’ll be surprised by the result…
And it is NOT less than the current 1.22.
Euroland (excluding GBP which is now on the mend given that we have just kicked the largest taxsucking leech from office) is in a mess and will overshoot PPP by a margin (whatever that really is). But a fair EUR/USD PPP value is closer to 1.20 than the parity argument most now reckon and if the Euroland disintegrates and DM underpins the residual currency deposit base, then short EUR/USD will burn.
Personally, I think you have this recommendation too late and your Big Mac analysis is about as sound as the actual Big Mac index data itself…
The Euro is not sound but most of the goverments will aim to defend it’s existence to the bitter end for the ultimate political goal.
But value is relative.
Your relative value assesment is flawed.
Your recommendation is way too late.
And I’ll bet you USD 10,000 that we see USD/EUR 1.30 before we see parity (even odds).
Want a bet?
Joe
PS. The Economist Big Mac index that you posted is undated and probably well out of date given currency movements. Want to share with us the latest index based on today’s exchange rates?
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A Chinese “Big Mac” is more like a “Tiny Mac.” The last time I had one, it was a special order. In other words, I had to wait while they cooked it.
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