Use currency indices to help diversify your forex trading
CURRENCY markets have proved particularly popular among contracts for difference (CFDs) traders over recent months, due to the extent of opportunities in the forex markets as risk appetite waxes and wanes.
But one of the problems with CFD positions on currency pairs is that in order to be bullish on one currency, by definition you need to be relatively bearish on the other, even if your view is that both have plenty of upside potential to come.
And when trading currency pairs – particularly those involving the majors such as the US dollar, the euro and the yen – it is difficult to anticipate the impact of newsflow on such global currencies. At least this used to be the case. CFD providers such as CMC Markets are now offering CFDs on currency indices, which allow you exposure to a single currency, by offering a portfolio approach which tracks the economic performance of a specific currency against a defined group of other currencies.
While currency indices have been an actively traded financial markets instrument for many years, it is only recently that they have been taken up by the private investor. In most cases, they are weighted according to the exports and imports of goods by a country, called a trade weighted index.
Trading currency indices has two distinct advantages for the private trader. Firstly, it allows you to take an overall bullish or bearish view on one currency without forcing you to have an opinion on any other currency.
James Hughes, market strategist at CMC Markets, says: “In these times of increased economic uncertainty, trading a currency basket is something you should consider if you’re looking to exploit the fundamental strength or weakness of a currency.”
BLEAK OUTLOOK
Secondly, by trading a currency against a basket of its major trading partners, the impact of currency-specific news will often be neutralised. For example, if you believe that the economic outlook for the Eurozone is bleak and this will prove negative for the single currency, you may wish to sell euro-dollar.
While this is a highly rational trading strategy, it might get derailed should a strong dollar-negative impact emerge – for example, a resurgence in risk appetite or China announcing that it will no longer treat the US dollar as a reserve currency. You can therefore find that the euro strengthens against the dollar despite falling overall against the basket of currencies. In this case, it would not have been profitable to have sold euro-dollar but had you held a short CFD of the euro index, you would have been in the black. Obviously, though, the downside of this tactic is that you will see diluted returns, compared to what you can get from a single pair. Effectively, it’s way of not putting all your eggs in one basket.
SAFE-HAVEN TRADING
The safe-haven trading that is occurring at the moment means that going long on the dollar index could well be a profitable trading strategy, says Richard Turner, foreign exchange sales dealer at IG Index. Yesterday, both the US dollar and the Japanese yen strengthened on the back of crumbling risk sentiment – last week’s dismal US non-farm payrolls cast a shadow over the potential for a sustained global economic recovery, sending investors scrambling into safe-haven assets.
But Turner says that a long dollar index trade would only be a short-term one, due to continuing concerns about the global economy. “If there is a double dip then it would massively benefit the dollar and you would want to go long on the dollar index,” he says.
With newsflow driving risk sentiment, it can be useful to be able to take a view on one particular currency such as the safe-haven US dollar or the risk-loving Australian dollar without worrying about another specific currency.