Over the last eight months, the U.S. Dollar Index has been trading in a very tight range between $79 and $82. Even looking back over the past two years, the 79 has acted as support for the index. The weekly chart below shows the price range of the past eight months with support at 79 and resistance just below 82.
The question becomes, with such a tight range, how can you make money trading the dollar without trading currencies? There are two ways to do so, but one of them could have a much larger upside for you.
As is the case with almost any investment class, there are currency exchange-traded funds (ETFs) that make it easier to trade currencies, including the dollar index. Notice how I said easier to trade, not easier to make money.
The most actively traded of the ETFs that focuses on the U.S. dollar is the PowerShares DB US Dollar Index Bullish Fund (UUP). The UUP only uses long USDX futures contracts, which are simply agreements to buy or sell the USDX at a pre-determined price in the future. Those USDX futures allow traders to be long the dollar against a basket of the other main currencies of the world – Euro, Yen, Pound, Canadian Dollar, Swiss Franc and Swedish Krona.
Even though the UUP is designed to emulate the movements of the U.S. dollar, it is using futures, so the tracking isn’t perfect. One look at the weekly chart below and you see what I mean. While the dollar index itself has been in a very tight range with a clear upper rail and lower rail, the UUP has had a little more variance. Even with that said, the 52-week high is $22.98 while the 52-week low is $21.14. Not exactly the most volatile of ETFs now is it?
Personally, I think the dollar is ready for a bounce against the other currencies. We are starting to see some signs that inflation in the U.S. is creeping up a little and the Fed may have to act and raise rates as a result. When a central bank raises rates in that country, they are essentially raising the price of that currency. Think of it this way: in basic economics, when demand is higher than supply, the price rises. When supply is greater than demand, the price falls. When you are talking about a currency, the price of that currency is the interest rate.
The problem with playing the dollar, other than by trading currencies directly, is the lack of volatility in the index and in the UUP. You can buy it down in the $21.50 range and hold it for 6-12 months, be right about the rebound and still only see the UUP up to $23. Returns of 7% are ok, but they don’t exactly get me excited.
I think the best way to play the UUP is with options. An options contract offers you the option to buy (call) or sell (put) shares at an agreed-upon price (the strike price) by a certain date (exercise date). For instance, as of this moment, you can buy the January 2015 20-strike call on the UUP for $1.55 ($155 because they represent 100 shares).
Without getting too complicated, the price of an option is made up of intrinsic value and time premium. For call options, the intrinsic value is the difference between the underlying stock’s price and the strike price. With the UUP trading at $21.50, these options have $1.50 of intrinsic value and the other $0.05 is time premium. Even though they won’t expire for another eight months (in January 2015), there is only a nickel of time premium.
Now, should the price of the UUP go up to $23, that January 2015 20-strike call will have an intrinsic value of $3, which is double the current price of the option, so you would be looking at a gain of 100% on your trade. Investments that double are much more exciting than ones that gain 7%, but trading isn’t for everyone. If the price of the UUP is below $20 come next January, the option is worthless, and so you want to be careful with how much you put into an options trade.
The bottom line is that I see the dollar rebounding over the coming six months to a year. You have to decide if and how you want to play it. I like the idea of making a smaller investment in the options and going for a bigger win, but that is just me.
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