This post originally appeared in FutureSource’s Fast Break Newsletter on February 15, 2011, where Craig Turner is a regular contributor on various futures trading topics.
Every position you’ve had in the past, currently hold, or hold in the future can be viewed as a spread trade. You might be saying to yourself, “I only trade the Gold, Crude Oil or Equities, I don’t trade spreads or get involved in pairs trades.” Au contraire, mon frere, I beg to differ. For example, when you buy crude oil, you are long a crude oil futures contract but you are giving up something in return. You are giving up USD to be long crude oil. Your long crude position is also a short USD position. So if you are long crude, you are really in a long crude/short USD cross, or “Crude Oil/USD”. You can apply this concept to any market you are long, whether it be stocks, real estate, or commodities.
Is this important? Am I just being a smarty-pants, know-it-all broker? Perhaps, but consider this. Wouldn’t you want to know how much exposure your portfolio has to currency and systemic risk? Wouldn’t you want to hedge that risk the best you can? If this is important to you, then you need to understand the synthetic positions your current portfolio already holds. Understanding your risk to currency and systemic risk will allow you to hedge against the next great-unknown event that causes the markets to crash.
Now that I have your attention, let’s go back to our crude oil example. If you are long crude oil futures, what happens if the USD has a sudden rally? Crude oil will decline because Crude is priced in USD. This implies that if you are long crude, you also have a short position in the USD. So if the USD rallies, there is a good chance that your “Crude/USD” position declines and goes against you.
This is the same for any asset or market in which you have a long position. Whether the position is in stocks, gold, real estate, or commodities, chances are you own these assets in terms of US Dollars. The opposite is true when you are on the short side. For example, let’s say you are short Gold. When you short Gold you are now receiving USD in return for selling Gold. You can view this as long USD and short Gold, also known as USD/GOLD. Your synthetic long USD/short Gold (USD/GOLD) position will tend to lose money if the USD declines and make money if the USD increases in value.
All Investments Have Currency Risk
Understanding how much risk you have in your portfolio due to currency risk is the first step in hedging against systemic risk and the next big crash. Let’s say your portfolio is long individual stocks and equity indexes. If you are only just long the equity market, you also have one additional giant short USD position. If you are long 10 stocks, the S&P 500 index, the Russell 2000 and the NASDAQ, you probably also own all of those in US Dollars. You can look at that entire position as long equities and short the US Dollar. Sounds like a spread trade to me.
This is not just true for equity portfolios, but for futures traders too. Let’s say you are long Crude Oil, Gold, Corn and the Euro. You might think you have a nicely diversified portfolio of commodity futures positions. However, they are all priced in the US Dollar (Crude/USD, Gold/USD, Corn/USD, EUR/USD). In one sense, you have a massive short US Dollar position. Again, it is important to remember for every long futures position you have that is priced in Dollars, your also have a short US Dollar position. For every short futures position you have, you also have a synthetic long US Dollar position.
The US Dollar Represents the US Economy
Why does all this matter? Who cares if all of your positions are held in US Dollars? If that is what is going through your mind right now, then you need to consider the following. What does the US Dollar represent? The US Dollar represents the US Economy as a whole. The value of the US Dollar is relative to other foreign currencies based on the strength of their economies, GDP, interest rates, employment and many other macro economic factors. If the US Dollar represents the US Economy, then it must also represent systemic risk. The state of the US Economy can have a major effect on the markets. We only have to go back a few years when we were in the Sub-Prime crisis and Lehman Brothers failed to prove that point. If you truly want to diversify your portfolio to have as little exposure to systemic risk as possible, you need to hedge out the US Dollar.
For example, let’s say a European country’s banking system is about to fail, and their largest banks need to be bailed out by the European Union. To make matters worse, let’s assume the market was completely caught off guard, and the Euro plummets and sends the US Dollar much higher. The Dollar rally puts downward pressure in all commodity futures priced in dollars. If you are long Crude, Gold, Corn and the Euro, they are all declining together. The correlation between those four futures positions becomes 1.0 because they are all priced in Dollars. They act as one large losing trade against the US Dollar.
The same situation can happen to a portfolio that is made up of entirely individual stocks, equity ETFs and stock indices. You may think you have a diversified portfolio, with equal weights to many different equity sectors. However, if you are just long equities, you have a massive short USD position in your portfolio. Think back to when the market thought Greece was going to have to default on its debt. Did the US Dollar rally? Yes, it did. Did your stock portfolio lose value? Yes, it did. Luckily, Greece was bailed out and the market eventually made up the losses and traded higher. However, what would happen if it was a major economy that failed? What if it was an economy that could not be bailed out as easily as Greece (which in economic terms has an economy smaller in size than Massachusetts)? What would happen then? A repeat of what happened to the stock market in 2008 is not out of the question.
Hedging Systemic Risk by Hedging the US Dollar
How do traders hedge out the USD and protect against systemic risk? The answer is simpler than you may have expected. If you are long a market (and short USD) then you need to be short another market (and long USD). The short USD and long USD positions will cancel each other out.
Let’s go back to our long Crude Oil example. We are long Crude Oil, so then we must be short USD. We are in a “Crude/USD” spread. Now let’s say we are bearish Gold and we short that market. We are short Gold, so then we must be long USD. We are in a “USD/Gold” spread.
Let’s now assume those are the only two positions in our portfolio. We are long Crude Oil and short Gold. Take a look when we combine the two individual positions in our portfolio:
2) Short Gold, Long USD = USD/GOLD
CRUDE/USD + USD/GOLD = CRUDE/GOLD
We have hedged out the USD. We now own Crude in terms of Gold. What is important here is not the specific fact that we own Crude in terms of Gold and not USD. The important thing to take away is the concept. You can apply this trading technique to any market in order to hedge your currency risk, US Dollar risk, and ultimately your systemic failure risk in the markets.
When the markets crash, the US Dollar becomes a “flight to safety” asset, making most, if not all, assets priced in USD decline. When the markets crashed in 2008 both Crude Oil and Gold declined to annual lows. A portfolio just long crude oil would have taken a severe loss. However, the portfolio that hedged out its currency risk would have been ride out the storm as its short positions were able to make up for the losses in the long positions.
By having a few short futures positions to go along with a few long futures positions, you greatly hedge out your US Dollar exposure. The next time a major, unforeseen economic event happens, you will be better protected against systemic risk. The short futures positions help diversify the systemic risk built up in the long positions. Your ability to hedge out part or all of your US Dollar risk is an insurance policy against the unknown systemic risks in our financial system.
To learn more about Hedging Systematic Risk, please see our previous article solely dedicated to this very important subject.
Spread Trading
Traders who are aware of currency and systemic risk will actively look for alternative strategies to reduce this risk. Many of them turn to spread trading, also known as pairs trading. There are typically two types of spread trading, seasonal and non-seasonal.
Seasonal futures spread trading is when traders spread two related contracts based on seasonal supply and demand. Many markets have seasonal cycles and traders will try to take advantage of those moves. These seasonal patterns within the same market like being long old crop Corn and short the new crop. Seasonal patterns also exist between different but related markets like Live Cattle and Lean Hogs. The markets and months will change during the year, but one thing is the same, the traders are using historical seasonal patterns to enter and exit their positions. If you would like to know more about this exciting way to trading the market, please see our Seasonal Futures Spread Trading article.
The second type of spread trading is what I call non-seasonal, which is just about every other kind of spread trading. Some traders like to trade the Emini NASDAQ against the Emini S&P. Some will trade Corn vs. Wheat based on either fundamental or technical analysis, but not necessarily historical seasonal performance. Others may just want to reduce their risk by getting either long or short the front month, and then do the opposite in the deferred months to hedge their systemic risk. If you would like to know more about his kind of trading, please see our Wonderful World of Futures Spread Trading article.
All Positions are Spread Trades
Investors and traders need to get used to thinking of all of their futures positions as Spread Trades. By thinking of your investments this way, you will have a greater handle of the currency and systemic risk your portfolio is exposed to. If you think you could benefit from a publication that addresses the markets with these concepts in mind, then I highly recommend you register for a complimentary subscription to my weekly Turner’s Take newsletter. With the knowledge and understanding of how currency and systemic risk can effect your investments and trading, you will be prepared for the next time we are in a financial crisis.
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