Successful trading requires a focus on the risks you accept in pursuit of profits. Diversification is usually considered to be one of the best ways to reduce risk.
Many investors hold stocks and bonds believing that when stocks fall, bonds should go up because investors will sell the riskier asset (stocks) while seeking the relative safety of bonds.
More sophisticated strategies add gold, real estate, currencies and other asset classes in pursuit of diversification.
Using trading strategies to time buys and sells of alternative investments could be a way to improve results, and right now, we have a chart pattern saying “buy” in an asset that could diversify your portfolio while taking advantage of a downtrend that has lasted for nearly 100 years.
Many traders are familiar with charts like the one shown below that indicates the U.S. dollar has lost more than 95% of its purchasing power since 1913, the first year that data is available.
One way to take advantage of this trend is to go short U.S. dollars, a trade that can easily be completed in the foreign exchange market. This trade can also be completed by buying CurrencyShares Euro Trust (NYSE: FXE), which is long the euro and, in effect, short the dollar. FXE appears to be completing a bottoming pattern that looks like a cup-and-handle formation and offers the potential for a long-term gain of about 12%.
Using the recent lows in the handle formation near $127 as a stop-loss level, risk should be limited to less than 3%, including commission costs and slippage. This makes FXE a trade with an exceptionally attractive reward-to-risk ratio of about 4:1.
Based solely on the news, this may not seem like the best time to buy the euro. But currency trades are always relative to another currency, and the euro has been stronger than the dollar recently.
This is shown in the next chart, which plots the relative strength (RS) of the euro in a point-and-figure (P&F) format. A P&F chart ignores time, which makes it easier to see the direction of the trend.
The column of Xs on the right side of the chart shows that the euro is a better long trade now than the dollar. The Xs are used to show an uptrend and Os mark declines. Small changes in RS are ignored, and a switch to a new column is only made after the trend reversal is confirmed.
This type of chart is useful when we see a small price consolidation like the handle in the chart of FXE. If the RS trend is up, like it is now, we should expect to see prices move higher.
The euro’s strength may only mean that it is less weak than the dollar. Some analysts have said that currencies around the world are in a race to the bottom as nearly all developed countries are using stimulus programs in an effort to generate economic growth. The European Central Bank is doing just that, and that may lead to a long-term drop in purchasing power for European consumers. However, for investors looking to profit from the dollar’s decline, the euro seems to be the best currency to accomplish that objective.
One reason many traders overlook currencies is because the price moves tend to evolve slowly. While FXE could be set up to provide a 12% gain, based on the length of time it took to form the pattern, it is reasonable to assume that it will require at least six months to reach that target.
Options can be used to increase the gains on a percentage basis, but it will still require time for the price move to unfold. An advantage of options is that they allow traders to commit smaller amounts of money to the position.
Options expiring in June should allow enough time for FXE to meet the objective based on the chart pattern. Call options with a strike price of $138 are trading for about $0.75. If FXE reaches the price target of $144, these calls would have an intrinsic value of $6 and the potential gain for traders buying at $0.75 is 700%. If no stop-loss is entered, the potential risk is 100%, but the dollar amount risked ($75 per hundred shares) is less than the amount risked to take the trade with the ETF.
FXE can help traders diversify their dollar-based investment portfolios. This trade could take months to develop, and call options may be the best way to benefit from the potential strength of the euro because they require only a small amount of trading capital.
– Michael J. Carr & Amber Hestla
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Source: Trade of the Week
Disclosure: None.
