News & Analysis

US share or option trader: Managing currency risk?

November 26, 2019

 

Many traders utilise shares or options amongst their investment strategies either for income or capital growth.
One key factor that such traders may consider in their choice of specific markets to trade is liquidity, with a higher trading volume impacting positively on the ability to get in and out of trades at a fair price.

Others may find the choice to trade specific companies or sectors not as well represented in their local market.
For many therefore, the breadth of choice and liquidity may make this market the preferred market to trade.
Like any type of trading, sustainable results require a depth of knowledge and commitment to trading an individual tried and tested system. This system should include in depth reference to risk management throughout.

However, due to the choice of market, a trader can make regular profit and yet lose this (and potentially more) through the currency risks associated with trading in US dollars rather than, for example, their base currency of Australian dollars or GB pounds.
Holding a significant position in US shares or options means that many traders have exposure to positions in tens of thousands in USD.

So what is the currency risk?
The reality is that profits can be ‘used up’, or losses can be compounded, by adverse currency movements.
The reason for this is simple. Let’s assume that your currency is AUD and it is transferred into USD for trading purposes. The exchange value when converted back to the original currency at some time in the future will be dependent not only on trading results but on the movement of AUD versus USD.
While your money is in your account in USD, weakness in AUD will mean a greater worth in AUD when converted back, whereas a lesser conversion worth will result if there is AUD strength while your money is sitting is USD.

Let’s give an example…

See below a daily chart of AUD/USD for the last 3 years.

 

Note the price from the end of January 2018 at a level of 0.8134.
The price at Nov 2019 was at 0.6776 so a difference of 0.1358

So, an investment to fund a trading account of AUD$30,000 would have equalled an original USD value of $24,402.
With the movement in the currency alone over this period (assuming no movement in share price) the value of the account when transferred back into AUD would have risen to $36,007.59 or in other words a 20.03% increase. So, in this case the underlying currency movement was of benefit.

However, if this positive currency outcome is the case when there is USD strength (when your trading capital is in USD), with the same AUDUSD currency movement in the other direction, the loss could be 20.03%. This would mean that you would have had to profit by this 20.03% in your trades simply to breakeven. This WAS the case if you look at a chart from the beginning of Jan 2016 to Aug 2017.
More than this of course, if you have lost $6007.59 on a similar price move in the other direction, broke even on your trades during that period, so your equivalent AUD value is $23,992.41, your trading return would have to be now 25% profit to recover the original capital level simple because of currency movement.

Bear in mind, of course we have chosen only a $30,000 example, some of you may have considerably more than this in the market (and so considerably more currency risk) than the example we have given.

Risk management of your hedge
Although you are entering a low margin requirement Forex position due to the leverage associated with Forex, we cannot understate the importance of a full understanding of the implications of this. Should the AUD move lower still (as we explained above in looking at what has happened since January 2018), the value of your hedge may move significantly.
If we look at using the analogy of an insurance policy in trying to explain the concept, the maximum risk is the initial “premium” paid in this case. However, with any Forex position there is obviously the risk of losing more than your original investment.
Additionally, you are trading your shares/options in a different account and hence there must be the ability to money manage between the two accounts.
Our team can guide you further on these important issues.

 

One last thing…
Although we cannot advise when it is right for you, if at all, to put in a currency hedge, it is worthwhile raising the question about what the current AUDUSD chart is telling you now technically. Additionally, with the potential for further US rate cuts, and if you believe there will be some resolution to trade tariff wars between the US and China, both events have the potential to strengthen AUD (and so weaken your USD capital). If invested in USD based trading for some time you have benefitted, logically, it is not unreasonable to consider whether it is worth ‘locking’ some of this in.

So, what can you do?
Your choices are twofold.
1. Allow your invested trading capital to be subjected to the risks associated with underlying currency movements or,
2. Hedge the currency risks with a non-expiring Forex position.

If option “2” looks attractive, the reality is you can:
• Mitigate the risk through consideration of a Forex hedge.
• Attempt to optimise your hedge by timing its placement and exit i.e. use technical landmarks, to decide when to get in and out of a hedge. (Please note: a hedge is for insurance purpose and so although there may be merit in timing entry and exit, we are not suggesting you trade in and out of a hedge on a regular basis).

Learn how to reduce the risk
We are happy not only to show you how but guide you step by step in how to set this up. There are a couple of practical issues you would need to have in place to manage this well but again we can go through these to enable you to make the right decision for you.
If you think this might be for you, then simply connect with us at mike.smith@gomarkets.com and we will arrange for one of our account team to discuss a currency hedge that may be a fit for you.

 

Mike Smith
Educator
GO Markets

Disclaimer
The article from GO Markets analysts is based on their independent analysis. Views expressed are of their own and of a ‘general’ nature. Advice (if any) are not based on the reader’s personal objectives, financial situation or needs. Readers should, therefore, consider how appropriate the advice (if any) is to their objectives, financial situation and needs, before acting on the advice.

Click here for more information on trading Share CFDs, also, see our Index Trading page for information in trading Indicies.

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