Trading individual currencies, just like individual stocks, can be frustrating even for seasoned forex traders. Certain that the dollar will weaken, you may place your bets in the euro, only to watch as the pound appreciates instead. Or, perhaps you base your analysis on one or two relationships, when a broad market view is what you needed. Situations such as these are where trading a basket of currencies comes in handy.
Until recently, the only direct solution to trade a basket of currencies has been the U.S. dollar index (USDX), listed on the Intercontinential Exchange (ICE). This is a weighted geometric mean of the dollar’s value versus the euro, the Japanese yen, the British pound, the Canadian dollar, Swedish krona and Swiss franc. We noted in "Greenwave: Calm in a sea of volatility," (September Trader Profile) how one trader created his own proprietary index to better hedge dollar appreciation.
The CME Group recently created a new dollar index that can be easily broken down into its component parts. The Dow Jones CME FX$INDEX consists of the four major currencies: the euro, Japanese yen, British pound and Swiss franc and the two top commodity currencies: the Canadian and Australian dollars.
This index, which is a simple average of the component currencies rather than a weighted geometric mean, is plotted opposite the dollar. This means that the uptrend shown in the index since June tells us that non-U.S. currencies have strengthened versus the dollar (see "New dollar index," below). The Dow Jones CME FX$INDEX component futures contracts are quoted in U.S. dollars per foreign unit.
While the index is new and has not reached a critical mass in terms of volume or open interest, its construction allows for some interesting trading opportunities that we will discuss here, even though the market has not matured to the point where someone could confidently execute these strategies.
The portfolio approach illustrates one way an index can be more effective than individual currency trades. One of the major themes of 2010 was the Greek debt crisis, an affliction that spread to several other smaller members of the Eurozone. The obvious trade was selling the euro, but the other European majors, the British pound and the Swiss franc, only reluctantly followed. Once that play ended in early June, foreign currencies futures rallied, catching the market short.
While searching for the right answer of what to do next, foreign currency futures kept advancing. Rather than betting on the wrong horse, namely the euro, traders in the index could participate in the move higher while avoiding the danger of being long the wrong currency pair.
The European or commodity currencies tend to move in the same direction, but at different rates. While the euro recovered from the Greek crisis, the British pound rallied harder because of the limited U.K. exposure to this particular crisis and other factors, such as the stabilization of the U.K. housing market. The relative strength of the pound versus the euro and the higher correlation between the Dow Jones CME FX$INDEX and the pound is obvious (see "Strength in index," below). Once again, going long euros was hard conceptually, but going long the index would be easier.
Trading a basket of currencies widens the speculative opportunities. You may favor one foreign currency against the other because you consider it common and easy. Going back to "Strength in index," it’s clear that the pound is outpacing the euro.
The beauty of the construction of Dow Jones CME FX$INDEX is that you can easily remove component risk or leverage component risk. Think of trading the Dow Jones Index where you could simply pull out three components in the exact size it appears in the index. You could do this on the days earnings are released and free up that exposure while maintaining your opinion on the rest of the index. You can do that with this index. Say you are long the index but feel that Japan is ready to devalue its currency, you can hedge out that exposure and remain long the other components versus the dollar.
The contract is designed to facilitate hedging. Simply, 10 Dow Jones CME FX$INDEX futures are the equivalent of four euro futures contracts, two Japanese yen contracts, two British pound contracts, and one contract each of Swiss franc, Canadian dollar and Australian dollar futures contracts. The index is calculated as the basket value divided by $10,000. Legging the euro out of the index simply means selling four euro contracts for each 10 long index futures.
Other benefits of the index include less sensitivity to volatility, short-term trading benefits, and cleaner technical analysis and systematic model signals.
Most traders can appreciate how an index compared to individual currencies can offer a healthy dose of protection against volatility and uneven reaction to events. In "Jobs shock" (below), you can see the forex reaction to the number one economic indicator in the United States: the non-farm payrolls.
This particular report was weak, so the foreign currencies futures rallied sharply. The five-minute chart displays both the Dow Jones CME FX$INDEX and the Australian dollar. Notice that just before the release of the data, the index rallied but the Aussie sank. Then the Aussie struggled to catch up with the rally of the majors, peaked prematurely and belatedly caught up with the up move of the index. In the second half of the chart, the Aussie tumbled while the index suffered only a mild pullback. The index provided a safer way to express demand for foreign currencies in response to a negative factor for the U.S. dollar. While this example is based on the calculated index and not actual prices, the simple construction of the index will make it easy for arbitrageurs to help keep it in line with its theoretical values.
Forces affecting the U.S. dollar have a way of overwhelming individual currencies. When you trade on the dollar fundamentals, you are forced to select which pair would best react to those fundamentals or trade the established dollar index. This steadiness also makes it easier to hold on to longer-term positions compared to individual currency pairs. While we all strive to identify trends, once we find them, we tend to fight them all the way to the end. It may be counterintuitive, but it’s not always easy to deal with the volatility. In "Steady mover" (below), you can see the inverse of the Dow Jones CME FX$INDEX and the dollar/yen. Notice the clear uptrend and then the shorter term downtrend in the index compared to the choppy moves in the dollar/yen, which made it quite difficult to hold long-term positions.
The trading strategies discussed here are theoretical as the Dow Jones CME FX index has not reached a critical mass in term of liquidity, but while most new futures contracts fail, those that succeed often have related markets for liquidity providers to lean on. That is the case here and if liquidity can build, currency traders will have a valuable tool in their tool box to managed risk.
Cornelius Luca is president of LGR (www.LucaFXTA.com). He is author of "Trading in the Global Currency Markets," Prentice Hall Press, 3rd edition 2007; "Technical Analysis Applications in the Global Currency Markets," Prentice Hall, 2nd edition 2000; "Technical Analysis Applications," McGraw-Hill, 2004; "Introduction to Technical Analysis," Euromoney Institute, 1997.