The Trader's U E-Letter: Issue #162
Wednesday, November 23, 2005
Trading Currency: How To Easily Play Moves in the Dollar with Three Distinct Investing Choices
by D.R. Barton, Jr.
Chairman, Trader's U
After four years of getting pushed around by the euro, the U.S. dollar has been strengthening in 2005. In fact, it's hovering close to the two-year high it made last week. And it is most likely not over.
Last week, I indicated that buying dollar strength looks like a good idea if it gets through a key level against the euro (1.1600 dollars). If the dollar strengthens to the point where the euro is worth less than 1.16 dollars, then we should be propelled into further dollar strength.
But how can you invest in or trade that belief? How does the average trader or investor buy and sell dollars? Let's look at the most common and accessible ways of trading currency…specifically how to invest in the dollar, and which instruments might be the most useful for your portfolio account.
Three Distinct Choices in Trading Currency and Investing in the U.S. Dollar
Whether you think the dollar will go up or down, if you want to trade or invest in it, you must have something to buy or sell. You could always run down to a bank or an international airport and exchange all your euros for dollars, or vice versa. But as anyone who has traveled to a foreign country knows, the transaction fees charged by banks or currency exchange kiosks are huge! So, let's look at some more practical alternatives within the strategy of currency trading, ranging from the futures and Forex markets to several available mutual funds.
1. The Futures Market
You can trade the dollar through the Chicago Mercantile Exchange's (NYSE: CME) currency futures contracts. Currently, the CME offers contracts in about 16 currencies versus the dollar, and one generalized dollar index that tracks the dollar compared to a weighted basket of seven other currencies. To trade these contracts, you have to open an account with a futures broker. Here are some pros and cons to futures trading:
- Advantages: Well-regulated, sufficient liquidity, highly leveraged, low transaction costs.
- Disadvantages: High leverage brings greater risk, so you have to keep up with expiring contracts.
- Bottom Line: Leverage makes this an instrument for seasoned and disciplined traders and investors; however, for those who have the experience and skill, this is the way to get the best bang for your trading dollar.
2. The Foreign Exchange Market (Forex)
The Forex market is used by institutions and speculators to exchange currencies around the world. In sheer turnover value terms, it is the largest financial market in the world. In the Foreign Exchange Market, all trading instruments are denominated in pairs, such as the euro / U.S. dollar pair, the U.S. dollar / Japanese Yen pair, or the euro / Japanese Yen pair. Almost all retail Forex trading is done in the spot market, meaning that the instruments are bought and sold for cash and have immediate delivery. In order to trade or invest in the dollar in the Forex currency market, you need to open an account with a Forex broker.
- Advantages: Highly liquid market, can achieve high leverage, very small account equity allowed by some brokers.
- Disadvantages: Poorly regulated - this is not an exchange-traded market…and almost all retail Forex trading is done with your broker taking the other side of your trade. Despite the claims of "free commissions," this is a relatively high transaction cost markets because the spread and slippage on trades can be very high.
- Bottom Line: The lack of regulation makes this a "buyer beware" type of market. The hidden transaction costs are much higher than meets the eye. These factors combine to make this a less favorable choice for most traders and investors. However, adventurous traders and those willing to take on leverage and fight through bad fills in fast markets can find a very active market for currency trading in Forex.
3. Mutual Funds in the Currency Market
Some of the more forward-thinking and leading-edge mutual fund families are now offering individual funds that allow traders and investors to play in the currency markets. All four of these funds correspond to the "Dollar Index" that was mentioned in the futures section above. The dollar index tracks the movement of the U.S. dollar versus a weighted basket of seven foreign currencies.
ProFunds (Nasdaq: RDPIX) has a fund that rises as the dollar index rises and an inverse fund that rises when the dollar index falls (Nasdaq: FDPIX). The Rydex fund family adds a twist by providing one fund that rises twice as fast as the dollar index (Nasdaq: RYSBX), and an inverse fund that falls twice as fast as the dollar index rises (Nasdaq: RYWBX).
- Advantages: Highly regulated, familiar instrument for almost all traders and investors, widely available, can be used in most retirement accounts including IRAs, classified as "no-load" funds.
- Disadvantages: Moderate transaction costs: While these are no-load funds, they still have an annual costs of 1 - 2% associated with using them; investors/traders can only buy or sell at the closing value each day; and many brokers charge additional fees if funds are not held for a certain period of time (this is not true if you open accounts directly with Rydex or ProFunds - two fund families that are rare in the mutual fund world, in that they are very friendly to short-term trading and investing, and fund switching).
- Bottom Line: This is a well-regulated method of trading currency for most investors to play the dollar's moves.
With innovative new products like the Rydex and ProFund dollar-based mutual funds, traders and investors can diversify their portfolios and benefit from moves in the dollar.
Today's TU Tips & Tricks
- In last week's Trader's U: The U.S. Dollar: Strong or Weak?, I went into some technical and fundamental details explaining the dollar's recent moves.
- And since last week's Trader's U, the dollar has tried to break through the 1.1640 area (dollars per euro) on three different days. This is according to plan, as I mentioned we should find strong support at the 1.16 area. On Tuesday, November 22, the Fed made overtures that we may be nearing the end of its interest rate hikes and the euro strengthened by almost 100 pips on the news. We'll see if there is a lasting effect of the Fed's new posture, but this announcement should make any bullish dollar investors more cautious.
The Chart of the Week:
(NYSE: HSY), located in Hershey, PA (scarcely more than an hour from your editor's house), is the home of the world's biggest chocolate factory. After some recent hard times, a big reversal day occurred on Monday, and has the stock showing strength in the face of slightly negative news. This could be a good value / technical trading play. A stop just under $52.50 could give a nice reward-to-risk opportunity.Great trading,
Trader's U Archives