Monday, 9 January 2012
For decades, if not longer, the U.S. dollar has been known as the world's reserve currency. Foreign investors and central banks have gobbled up greenbacks and debt issued by the U.S. government on the premise that the dollar is the world's dominant currency and American economic strength will bolster returns on dollar-denominated investments. While the conventional wisdom regarding dollar strength has proved to be true over the years, it is important that investors remember that currencies act just like stocks or other financial instruments. They enjoy runs of success and suffer through periods of doldrums. And while the dollar has been a highly desired currency for the international investing community, it experiences periods of decline. A fall in the dollar isn't cause for panic, though. Savvy investors can exploit the mighty greenback's decline when it happens and profit from it. Best of all, the avenues to profit from a dollar drop continue to increase. Where to Turn When the Dollar Tumbles There are generally a few key warning signs that indicate a decline in the dollar is on the horizon. A consistent pattern of key interest rate cuts by the Federal Reserve, a surge in the national debt and rising commodity prices, especially among gold and oil, can all help investors identify potential peril for the dollar. And when the dollar falls, that likely means other key currencies are rising, because investors are flocking to perceived quality. For example, a tumble in the dollar combined with rising exports and economic growth in Japan would lead investors to the Japanese yen. On the other hand, if U.S. economic growth is stagnant, but Europe and the U.K. are performing well, the euro and British pound become safe havens for currency investors. (For more insight, read Top 8 Most Tradable Currencies.) Another avenue to consider is the Swiss franc. While Switzerland is in Europe, the country doesn't participate in the common currency and likely never will. In addition, the Swiss government and central bank take almost painstaking efforts to keep the franc strong relative to competing currencies. As such, in 2009 the franc ranked as the world's fifth most-traded currency behind the U.S. dollar, euro, pound and yen. (For more, see What are the most common currency pairs traded in the forex market?) Watching the Dollar? Watch Commodities, Too Because many commodities are denominated in dollars, meaning their quoted price is in dollars, investors should watch certain commodity markets to get a sense of where the dollar is headed. For example, rising oil prices have generally resulted in dollar weakness because the dollar's purchasing power suffers and consumers get less gas for their cars and heating oil for their homes when crude oil prices rise. To hedge against the dollar's fall when commodities are in a bull market, look toward commodity-based currencies such as the Australian and Canadian dollars. When precious metals, such as gold, are in high demand, the Australian dollar often benefits. Likewise, Canada's dollar rises when demand for crude oil surges. Another more recent play on a commodity currency is the Brazilian real. Formerly an emerging market, in 2009 Brazil stands as the 10th largest economy in the world and is rich with natural resources, particularly oil. (For more, see Commodity Prices And Currency Movements.) Plenty of Options to Profit From the Dollar Decline Trading in the foreign currency markets can be daunting as the daily dollar volume in these markets dwarfs that of U.S. equity markets. Investors need to be aware that playing in FX markets is not for the faint of heart and they can lose more than their initial investment. For many, the best choice is to leave this arena to the professionals and seek out other methods for profiting from a fall in the dollar. Fortunately, there is no shortage of products to help investors do this. One is the U.S. Dollar Index, which tracks the dollar against a basket of foreign currencies. It is updated 24 hours a day, seven days a week and trades on the New York Board of Trade. There is also a plethora of mutual funds that track foreign bonds or short the dollar against the other currencies. These funds give investors the international exposure their portfolios need without the headache of directly tracking wild intraday swings in the currency markets. (For more insight, see Taking Advantage Of A Weak U.S. Dollar.) Equities, both international and domestic, provide another area for investors to profit from a dollar slide. If the forecast appears grim for U.S. equity markets, certain foreign markets may be poised to benefit. Of course, there are U.S. stocks that can benefit from a fall in the dollar, too. Large multinational firms that count on overseas markets for a fair amount of their profits benefit when the dollar is weak as they convert a British pound or Japanese yen back into a greater amount of U.S. dollars. Names like Procter & Gamble (NYSE:PG), General Electric (NYSE:GE) and PepsiCo (NYSE:PEP) come to mind. (For further reading, see Currency Moves Highlight Equity Opportunities) Conclusion Investors need not suffer at the hands of a weak dollar. The methods to protect one's dollar-based investments are plenty and effective hedging can serve as more than just protection: it can boost a portfolio's bottom line. In addition, the global economy means there are global opportunities to help investors sleep a little easier when the dollar drops.
When it comes to understanding the long and short of investing, most beginner investors must learn what seems like a new language. In fact, the phrase "the long and the short of it" originated in financial markets. In this article we discuss certain key terms that will help you better understand and communicate with other market participants. These terms are used in the equity, derivative, future, commodity and forex (or currency) markets. You will learn what buying, selling and shorting really mean to investors and how they can use certain terms interchangeably with more confusing words like bullish and bearish. To compound the issue, options traders add in a few other terms like writing a contract versus selling one. When you can communicate properly, you will be better informed and can make wise investment decisions. The Long and the Short of It The financial markets allow you to do a few things that are really common in everyday life and a few things that aren't. When you buy a car, you own that car. In the stock market, also known as the equity market, when you buy a stock, you own that stock. However, you are also said to be "long" on the stock or have a long position. Whether you are trading futures, currencies or commodities, if you are long on a position, it means you own it and hope it will increase in value. To close out of a long position, you sell it. Shorting will likely seem somewhat foreign to most new investors because shorting a position in the equity market is selling stock you don't actually own. Brokerage firms allow speculators to borrow shares of stock and sell them on the open market, with the commitment to eventually return the shares. The investor will then sell the stock at the day's price in the hope of buying it back at a lower price while pocketing the difference. Catalog companies and online retailers use this concept daily by selling a product at a higher price, and then quickly buying it from a supplier at a lower price. The term originates from the situation where a person tries to pay a bill but is "short" on funds. You may be interested to know that some people consider shorting to be unpatriotic or "bad form." During the Great Depression, John Pierpont Morgan (J.P. Morgan) was famous for the phrase, "Don't sell America short." He was attempting to influence short sellers from pushing stocks lower. (The debate against short selling rages on to this day. See Short Selling: Making The Ban and Questioning The Virtue Of The Short Sale.) The Currency Caveat When trading foreign currencies in the "spot" market (currencies and many commodities are traded in the futures or spot markets), you are usually long one currency and short another. This is because you are exchanging one currency for another and therefore, various world currencies trade in pairs. For instance, if you think the U.S. dollar is going to rise but the euro is going to fall, you could short the euro and be long on the dollar. If you feel the dollar is going to rise and the Japanese yen will fall, you could be long on the dollar and short on the yen. (Also check out our Forex Tutorial for more in-depth explanations.) Sentiment Speak Other terms that are often new to beginning investors are "bullish" and "bearish." The term bullish is used to describe a person's feeling that the market will go up, while bearish describes a person who feels the market will go down. The most common way people remember these terms is that a bull attacks by ducking its head and bringing its horns upward. A bear attacks by swiping its paws down. Chicago is the home of commodity and futures markets; these markets are so ingrained within the identity of the city that the professional basketball team is the Bulls and the professional football team is the Bears. In fact, the Chicago Cubs' mascot is a bear cub. Only the White Sox seem to be the odd one out in this correlation. (To learn more, see The Wall Street Animal Farm: Getting To Know The Lingo.) It is also common for investors to use the terms "long" or "short" to describe their market sentiment. Instead of saying they are bullish on the market, investors may say they are long on the market. Similarly on the downside, investors may say they are short on the market instead of using the term bearish. Either term is acceptable when describing your market sentiment; if you are bearish, you may also say you are short; if you are bullish, you may also say you are long. It is important to remember that short and long usually imply that you have a certain position in whatever market you are trading, but as you can see, that isn't always the case. Derivative Dialects The derivative market is also known as the options market. Options are contracts in which one party agrees to buy or sell a certain security (security is a generic term for any financial product) at a set price and set time to another party. Options are very common in the equities market but are also used in the futures and commodities markets. The forex, or currency, market is known for very creative derivatives known as exotic options. For our purposes, we'll refer to options in the stock market since it is most investors' first introduction to derivatives. Options come down to calls and puts; call options give the contract buyer the right to purchase stock shares at a set price on or before a set date. Usually another investor will sell a call contract, which means they believe the stock will stay flat or go down. The person who buys the call is long on the contract, whereas the person who sells the contract is short. A put option allows the contract buyer to sell stock at a set price before a set date. Like a call option, there is usually another investor willing to sell the option contract, which also means that investor believes the stock will either stay about the same price or rise in value. So the person who buys the option contract is long on the contract and the person who sold the contract is short. Selling options while using the derivative dialect also gets more complicated because not only do they use the terms "sell" or "short" regarding the contract, option traders will also say they "wrote" a contract. Today, the contracts are standardized and no one really "writes" the contract, but the term is still very common. Covered calls are often one of the first option strategies investors learn; these involve the purchase of a stock and the sale of a call contract at the same time. The stock purchased acts as "collateral" in case the call is exercised by the option buyer and the seller can relinquish the shares while keeping the premium gained for selling the option. Because investors are buying a stock and selling a call at the same time, they use a "buy-write" order. (Refer to our Options Basics Tutorial to explore these topics in more detail.) Market Double Talk At this point, you may find yourself going back to reread some of the vocabulary that was just discussed. Let's do a quick recap. Investors will either say they are bullish, or long, on the market, or bearish, or short, on the market. If we are long one currency in the forex spot market, we are short another currency at the same time. This can be confusing but not nearly as confusing as the options market. In the options market, we can say we are bullish on a stock and then short a put because while being bullish, we can either buy a call or sell a put. We can be bearish on a stock and be long on a put because if we are bearish, we can either buy a put or sell a call. This may also mean that we are short on the market by going long on a put or long the on market by shorting a call. You can imagine the linguistic laughter that comes from a group of option buyers talking to each other. In many cases, and not just in the financial world, overcoming the language barrier will be one of the vital keys to success. Investing carries with it its own language barricades that must be broken down by translating the terms and subduing the syntax.
With the increasingly widespread availability of electronic trading networks, trading on the currency exchanges is now more accessible than ever. The foreign exchange market, or forex, is notoriously the domain of government central banks and commercial and investment banks, not to mention hedge funds and massive international corporations. At first glance, the presence of such heavyweight entities may appear rather daunting to the individual investor. But the presence of such powerful groups and such a massive international market can also work to the benefit of the individual trader. The forex offers trading 24-hours a day, five days a week, and the daily dollar volume of currencies traded in the currency market exceeded $3 trillion in 2007 (according to the 2007 Triennial Central Bank Survey of Foreign Exchange and Derivative Market Activity), making it the largest and most liquid market in the world. (To learn more about the forex market, be sure to check out our Forex Tutorial.) Trading Opportunities The sheer number of currencies traded serves to ensure a rather extreme level of volatility on a day-to-day basis. There will always be currencies that are moving rapidly up or down, offering opportunities for profit (and commensurate risk) to astute traders. Yet, like the equity markets, forex offers plenty of instruments to mitigate risk and allows the individual to profit in both rising and falling markets. Forex also allows highly leveraged trading with low margin requirements relative to its equity counterparts. Perhaps best of all, forex charges zero dealing commissions! Many of the instruments utilized in forex - such as forwards and futures, options, spread betting, contracts for difference and the spot market - will appear similar to those used in the equity markets. Since the instruments on the forex market often maintain minimum trade sizes in terms of the base currencies (the spot market, for example, requires a minimum trade size of 100,000 units of the base currency), the use of margin is absolutely essential for the person trading these instruments. Buying and Selling Currencies Regarding the specifics of buying and selling on forex, it is important to note that currencies are always priced in pairs. All trades result in the simultaneous purchase of one currency and the sale of another. This necessitates a slightly different mode of thinking than what you might be used to. While trading on the forex market, you would execute a trade only at a time when you expect the currency you are buying to increase in value relative to the one you are selling. If the currency you are buying does increase in value, you must sell the other currency back in order to lock in a profit. An open trade (or open position), therefore, is a trade in which a trader has bought or sold a particular currency pair and has not yet sold or bought back the equivalent amount to close the position. (Learn more in Common Questions About Currency Trading.) Base and Counter Currencies and Quotes Currency traders must become familiar also with the way currencies are quoted. The first currency in the pair is considered the base currency; and the second is the counter or quote currency. Most of the time, U.S. dollar is considered the base currency, and quotes are expressed in units of US$1 per counter currency (for example, USD/JPY or USD/CAD). The only exceptions to this convention are quotes in relation to the euro, the pound sterling and the Australian dollar - these three are quoted as dollars per foreign currency. Forex quotes always include a bid and an ask price. The bid is the price at which the market maker is willing to buy the base currency in exchange for the counter currency. The ask price is the price at which the market maker is willing to sell the base currency in exchange for the counter currency. The difference between the bid and the ask prices is referred to as the spread. The cost of establishing a position is determined by the spread, and prices are always quoted using five numbers (for example, 134.85), the final digit of which is referred to as a point or a pip. For example, if USD/JPY was quoted with a bid of 134.85 and an ask of 134.90, the five-pip spread is the cost of trading this position. From the very start, therefore, the trader must recover the five-pip cost from his or her profits, necessitating a favorable move in the position in order simply to break even. More About Margin Trading in the currency markets requires a trader to think in a slightly different way also about margin. Margin on the forex market is not a down payment on a future purchase of equity but a deposit to the trader's account that will cover against any currency-trading losses in the future. A typical currency trading system will allow for a very high degree of leverage in its margin requirements, up to 100:1. The system will automatically calculate the funds necessary for current positions and will check for margin availability before executing any trade. Rollover In the spot forex market, trades must be settled within two business days. For example, if a trader sells a certain number of currency units on Wednesday, he or she must deliver an equivalent number of units on Friday. But currency trading systems may allow for a "rollover", with which open positions can be swapped forward to the next settlement date (giving an extension of two additional business days). The interest rate for such a swap is predetermined, and, in fact, these swaps are actually financial instruments that can also be traded on the currency market. In any spot rollover transaction the difference between the interest rates of the base and counter currencies is reflected as an overnight loan. If the trader holds a long position in the currency with the higher interest rate, he or she would gain on the spot rollover. The amount of such a gain would fluctuate day-to-day according to the precise interest-rate differential between the base and the counter currency. Such rollover rates are quoted in dollars and are shown in the interest column of the forex trading system. Rollovers, however, will not affect traders who never hold a position overnight since the rollover is exclusively a day-to-day phenomenon. (Learn more in Understanding Forex Rollover Credits And Debits.) Conclusion As one can immediately see, trading in forex requires a slightly different way of thinking than the way required by equity markets. Yet, for its extreme liquidity, multitude of opportunities for large profits due to strong trends and high levels of available leverage, the currency market is hard to resist for the advanced trader. With such potential, however, comes significant risk, and traders should quickly establish an intimate familiarity with methods of risk management.