Trading currencies is known to be extremely challenging, but it can lead to significant returns if you know what you’re doing. The problem is that in order to know what you’re doing, you must have experience. And in most cases, the only way to gain experience is to learn through trial and error — you need to make mistakes prior to making adjustments.
When it comes to trading, mistakes means losses, which any investor wants to avoid. The only logical solution would be to allocate a small amount of capital to currency trading, knowing that you’re most likely to lose that capital. You can justify this by looking at it as paying for an education in currency trading. Then, of course, you can apply what you learned and be sure not to avoid the same mistakes. But this goes deeper than just money; it’s also time-consuming.
If you’re still going to trade currencies, then you would be best off trading major currencies, such as the U.S. dollar, the Euro, the Canadian dollar, and the Swiss franc. Venturing into exotic currencies isn’t likely to be a good idea for several reasons. (For related reading, see: Forex Exotic Currency Trading: Risks and Rewards.)
Exotic Currency Trading Risks
Here's a list of exotic currencies:
| ISK | Icelandic Krona |
| KWD | Kuwaiti dinar |
| PHP | Philippine peso |
| RUB | Russian Ruble |
| THB | Thai bhat |
| ZAR | South African rand |
| BRL | Brazilian real |
| CZK | Czech koruna |
| HUF | Hungarian Forint |
| INR | Indian rupee |
| JOD | Jordanian dinar |
| MXN | Mexican peso |
| PKR | Pakistani rupee |
| SAR | Saudi Arabian riyal |
| AED | UAE dirham |
| CLP | Chilean peso |
| EGP | Egyptian pound |
| IDR | Indonesian rupiah |
| IRR | Iranian rial |
| KRW | South Korean won |
| MYR | Malaysian ringgit |
| PLN | Polish zloty |
| SGD | Singaporean dollar |
| TWD | Taiwanese dollar |
| ARS | Argentinian Nuevo peso |
| CNY | Chinese Yuan Renminbi |
| HKD | Hong Kong dollar |
| ILS | Israeli New Shekel |
| UYU | Uruguay peso |
| IQD | Iraqi dinar |
The biggest problem with trading exotic currencies is that they’re illiquid. Since they trade at such low volumes, it makes it difficult to buy and sell these currencies when you want to. A lack of liquidity also leads to a wide bid-ask spread, which can increase your costs. Other problems include high markup fees, availability only at select markets and dealers, a lack of research on these currencies, and an increased likelihood of political upheaval that can lead to drastic currency swings. The one positive is that if you make the correct decision, then you could see a significant return, but this can take a very long time to play out — years — and even when you see the move you want, it can be difficult to find a buyer at that price due to the aforementioned lack of liquidity.
The only investors/traders that should have any association with exotic currencies are experienced ones with a lot of capital and a long-term time horizon. Anyone who is going to trade exotic currencies should be going in with a set-it-and-forget-it approach. In most cases, the people trading exotic currencies are international fund managers, not retail investors. Therefore, you might be asking yourself how the information provided here could pertain to you and your investing potential. (For related reading, see: Two Great Currencies to Profit from Oil Volatility.)
All numbers below as of Oct. 6, 2015.
Applying Logic to Major Currencies
If you look around the world, you will see that many central banks are still in the midst of applying accommodative monetary policies to their local economies, hoping it will help fuel growth. What matters from a currency standpoint is that by implementing these policies, these local currencies are being devalued. This is opposite of what’s taking place in the U.S., which has likely reached the end of accommodative monetary policy. By applying simple logic, the U.S. dollar should appreciate in this type of environment. However, that’s not the only reason the dollar is likely to continue its bull run.
You also have to factor in deleveraging. The U.S. government is nearing $19 trillion in debt, and private debt is north of $40 trillion. Eventually, these debts must be paid off or the process of deleveraging must begin. When it begins, it will remove huge amounts of the dollar from the economic backdrop. As dollars are removed and become scarcer, their value will increase.
What also might surprise you is that the dollar appreciated during the height of the financial crisis. This was due to deflation and deleveraging. It wasn’t until the Federal Reserve announced quantitative easing that the dollar began to depreciate and precious metals started their tear. But that won’t happen this time around because the Federal Reserve is out of ammunition.
In simpler terms, the Federal Reserve created artificial inflation for many years, which led to higher prices in equities, real estate, commodities, and more. Gold is a safe hedge against inflationary pressures, but that’s not the case in a deflationary environment. The recent run in gold was due to a weak jobs report plus two downward revisions for the previous two months. This led to the odds of a rate hike being greatly reduced for 2015. But the story of the Federal Reserve prepping to hike rates and then not doing so has been going on for years — the recent rally in gold as well as equities is more based on hot air than anything else. (For related reading, see: Should the Fed Be More Worried about Asset Bubbles?)
Trading Options
If you’re interested in trading currencies and desire liquidity — at least more liquidity than you will find with exotic currencies — but you don’t want to use Forex, then consider ETFs. They offer several ways to play current trends.
One option is to go long the U.S. dollar with PowerShares DB US Dollar Bullish ETF (UUP), which has appreciated 9.66% over the past 12 months. The downside is that it comes with a relatively high expense ratio of 0.81%. And, as you likely expected, there is no dividend yield. UUP also moves very slowly compared to most ETFs and stocks. On the other hand, with over 2 million shares traded daily, it’s liquid. Since the moves aren’t big and the patterns are relatively consistent, this would be an excellent place to think about implementing a trading strategy.
Another way to play it is to use ProShares UltraShort Euro (EUO), which has appreciated 21.98% over the past year. However, the expense ratio is 0.96%, there is no yield, and there are fewer than 1 million shares traded daily. Since EUO tracks 2x the inverse performance of the Euro, it’s also more volatile than UUP, which increases risk due to most traders being emotional.
A third and less attractive option due to a lack of liquidity is ProShares UltraShort Yen (YCS), which has appreciated 20% over the past year. The bad news is that it has a high expense ratio of 0.95% and trades fewer than 100,000 shares per day. Since it tracks 2x the inverse performance of the Japanese Yen, it’s also more volatile than UUP.
Also consider that as leveraged ETFs, EUO and YCS are rebalanced daily. Despite not having seen returns as high as EUO or YCS over the past year, UUP would likely be the best way to play the current currency environment.
The Bottom Line
If you’re going to invest or trade currencies, then it’s highly recommended that you stick with major currencies as opposed to exotic currencies. If you’re going to invest in major currencies, then you might want to look into the King — the dollar — by going long UUP. However, please do your own research or consult a financial advisor prior to making any investment decisions.
