This post is part of Craig Turner’s Innovative Trading Concepts series and originally appeared in FutureSource’s Fast Break Newsletter, where Craig Turner is a regular contributor on various futures trading topics.
Many investors and traders have too much exposure to the US Dollar. Owning stocks, bonds, real estate and commodities priced in USD creates massive exposure to the US Dollar. When markets crash, most asset classes are sold heavily and the US Dollar increases, in what is referred to as a “flight to safety” market reaction. The problem for most investors is that they conduct all of their investments or trades in US Dollars, so when the Dollar goes up, the rest of the market is going down. When the market crashes and you need diversification the most, most assets are sold and capital flees to the US Dollar.
Risk Management & Undiversifiable Risk
Any investor or trader, who has spent some time reading about risk management, has come across the terms “systemic risk”, “systematic risk” and “undiversifiable risk.” These concepts are built around the fact you are always long assets, and you are long in exchange for US Dollars. Furthermore, because your portfolio is always made up of “long only” positions, you are always subject to market collapses.
Your exposure to market risk does not have to be so extreme. You do have options, and it is easier than you think to reduce your “undiversified risk” in your portfolio. One way to reduce this risk is to hedge out some of your exposure to the US Dollar. This will not hedge out all of your undiversifiable risk, but it will help should the market crash. If you want to reduce your exposure to the US Dollar, then you need to buy the US Dollar Index futures contract.
Reducing Undiversifiable Risk through the US Dollar Index
The US Dollar Index is a futures contract that prices the US Dollar against a basket of foreign currencies. This basket of currencies is made up of the 57.6% Euro Currency (EUR), 13.6% Japanese Yen (JPY), 11.9% Great British Pound (GBP), 9.1% Canadian Dollar (CAD), 4.2% Swedish Krona (SEK) and 3.6% Swiss Franc (CHF).
If you are long the US Dollar Index, you are long the US Dollar and short the Euro, Yen, Pound, Canadian, Swiss Franc and Krona. If you are short the US Dollar Index you are short the US Dollar and long the basket of foreign currencies.
If your portfolio is made up of entirely long positions, bought in US Dollars, you can reduce your exposure to the USD through buying the US Dollar Index. The long position of USD in the US Dollar Index will cancel out with some of the short USD exposure in the long only portfolio, leaving those positions long in terms of the basket of foreign currencies.
Example: Long Gold
Let’s say you are long 100 oz gold at $1400/oz in the futures market. You are long $140,000 of gold priced in USD. This can also be viewed as gold vs. USD cross, or Gold/USD. In order to buy gold, you had to use US Dollars, so you are long gold and short dollars, which can be represented as long the Gold/USD cross.
Now let’s say you don’t just want to hold Gold in USD. You want to hold Gold in a mix of USD and foreign currencies. Your long Gold position is a Gold/USD cross. To hedge out the USD, you need to be in a position that is long USD and short something else. If you sold the EUR/USD cross, you would be short Euro and long USD. That would look like a long USD/EUR position. If you combined USD/EUR + the existing Gold/USD, the long and short USD would cancel each other out and you would be left with just GOLD/EUR, or long Gold in terms of Euro.
GOLD/USD + USD/EUR = GOLD/EUR
Now that we have that concept down, apply it to being long Gold (Gold/USD) and long the US dollar Index (USD/(EUR+GBP+JPY+CAD+CHF+SEK)). Long the US Dollar index at 80.000 is an $80,000 total contract value. Lets combine our long Gold and long US Dollar Index position and see exactly what it turns into:
- Long 100 oz Gold at $1400/oz = $140,000 GOLD/USD
- Long 1 US Dollar Index at 80.000 = $80,000 USD/(EUR+GBP+JPY+CAD+CHF+SEK)
The second position is long $80,000 US Dollar Index. That $80,000 long US Dollar in the second position will cancel out $80,000 of the $140,000 short USD from the first position. That leaves us long only $60,000 Gold/USD and the other 80,000 is now long Gold/(EUR+GBP+JPY+CAD+CHF+SEK).
- Long $60,000 Gold/USD
- Long equivalent of $80,000 Gold in terms of EUR, GBP, JPY, CAD, CHF and SEK.
I am now long gold in a basket of currencies. You can apply this method to any asset. The US Dollar Index’s total contract value is a multiple of $1000 against the Index. So if you want to hedge out $800,000 of USD exposure in your overall portfolio, all you need to do is buy 8 US Dollar Index contracts at 80.000. 80.000 X $1000 = $80,000 total contract value. $80,000 X 10 contracts = $800,000.
This example not only works with an investment in gold, but it can be any other futures contract, stocks, bonds, etc. All you are trying to do is reduce the net exposure you have to the US Dollar. If you think about it, if your total financial portfolio is made up of things you have bought (stocks, bonds, real estate, etc) with USD, you have one massive synthetic short US Dollar position (Portfolio/USD). That is why when the markets crash, your entire portfolio goes down. Everything is sold while the US Dollar is bid up.
Why Investors and Traders Need to Hedge their US Dollar Exposure
You never know when the next financial crisis will occur. You never know when we have the next flash crash or when the next European nation will default on its debt. By reducing your exposure to US Dollar, traders and investors can reduce their “undiversifiable risk.”
While the US Dollar Index can hedge out $80,000 of USD risk when priced at 80.000, the required margin for the US Dollar Index is only $1729 per contract. For a few thousand in margin a trader or investor can efficiently and effectively hedge out some of their currency risk to the US Dollar.
Some investors and traders I work with ask me why not just use put options for protection. The problem with put options is they are a wasting asset. The time decay on the puts makes it expensive to hedge against the unknown. Futures are not a wasting asset. If the US Dollar is trading at 80.000 noah, well w, and it trading at 80.000 three months from now, the P&L is $0. Anyone who ever bought an option, had the price of the underlying go unchanged for a few months, certainly knows that their option will be worth considerable less because of the time decay.
Take Action and Protect Your Portfolio
If you are concerned about your exposure to the US Dollar and US assets, you need to talk to your futures broker and figure out the best way to hedge some of your exposure to the US Dollar. If you don’t have access to an industry professional who understands hedging portfolio risk, give us a call at Daniels Trading and we will be more than happy to help you reduce your “undiversifiable” portfolio risk.