The Currency Exchange Trap In Trading Global Markets

Dean Whittingham created A Traders Universe - Trading System Development in 2005 as a resource site for traders of all levels, with education, courses, brokers, tips, free videos, newsletters, trading systems, simulations and a free 7 step process for building a profitable stock, futures or forex trading system.  Read how Dean illustrates how the change in currency exchange rates effect the overall performance of any overseas trade on your financial statement.

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Picture this: you live outside the US, let’s say Australia, you think the price of Oil is going to appreciate over the next month or two. Your options are to buy the commodity through the futures markets, buy a CFD, or buy an ‘oil’ based ETF. Either way, you will be buying an oil based asset and in which currency? The US dollar.

What happens? Well the price of Oil appreciates, and low and behold, so too does your purchase (whichever that may be), in fact it appreciates 20% over two months. Nice! Then something strikes you. You look at your financial statement only to be reminded that your sale price has been converted back to Australian dollars; naturally, this is where you live and so too does your broker.

So, what do you do, you flip back through your statements to the day when you made the initial purchase to see what it cost you in Australian dollars and then Whammo!, it hits you, as you realize your purchase price in Australian dollars was 10% more than what you just received. You didn’t make a 20% gain, you made a 10% loss! The Australian dollar appreciated during those two months.

The famous investor Jim Rogers was on CNBC one morning, so I decided to email a question to Martin Soong, to be directed to Jim Rogers, and the question simply was in general, “in your investing of commodities, all of which are priced in US dollars, how do you account for the fluctuations in your own currency?” You can see the interview, my question (around the 58 second mark), and his response here: http://www.cnbc.com/id/15840232/?video=1128688836&play=1 . Admittedly, I was a little disappointed with his answer, as his investment horizon is far more longer term than mine and as such I would have thought it an even more crucial factor for him than me, but it may also be that being as seasoned as he is, it may be something he does more instinctively or at a subconscious level.

Anyway, the point is, currencies can be volatile and can appreciate or depreciate massive amounts against other currencies at breakneck speed, and unless you are prepared for it, you may face losses in what appear to be good trades. We will look at a simple rule of thumb approach, as there are always other factors, including time, leverage and interest costs associated with that leverage.

The most general way to look at it if you are looking at overseas markets, and provided your trade ends up being correct, is that if you feel your own currency is going to strengthen, you are better off finding markets to short. If you feel your currency is going to weaken, then look for markets to go long. If you think your currency will be range bound, then you are a lot safer to play either way (long or short). If you go long a market and your currency also strengthens, this will reduce your profit potential (or even create losses as per example above). If however, you go short a market and your currency also depreciates, you have what is called a double whammy in your favor.

Let’s look at some simple examples to demonstrate this (these examples are not taking into account brokerage costs, or the use of leverage), and let’s for illustrative purposes, give the Australian dollar the value of exactly one US dollar at the point of the initial transaction and show the changes from there.

You purchase a US stock for $100. This will cost you $100 in US dollars, and obviously, $100 in Australian dollars. Look at what happens over a period of time, when the stock goes up 10%, and when the Australian dollar changes.

Purchase price $USD        100        100              100
AUD/USD Rate                    1.00       0.90            1.10
Sale price in $USD             110         110               110
Value in $AUD                    110         122.22        100
Percent change                   +10        +22.22       -10

We used a simple 10% change in the AU dollar, and a 10% appreciation of the US stock. When the AU dollar appreciated by 10%, the trade ended up being an overall loser of 10% in AU dollars, even though it went up 10% in US dollars. However, when the AU dollar, depreciated by 10%, the trade ended up being a 22.2% gain in AU dollars, even though it was only 10% in US dollars.

So I hope this illustrates how the change in currency exchange rates does affect the overall performance of any overseas trade on your financial statement.

Dean Whittingham,  A Traders Universe