Spreading Opportunities in U.S. Dollar & Euro ETFs

03/14/2019 6:00 am EST

Focus: FOREX

Paul Cretien

Retired Professor of Finance,

A higher currency price is a distinct disadvantage for a country wishing to sell products on the world market, writes Paul Cretien.

Movement in currency markets can be manipulated by countries trying to weaken the value of their currency to make products they produce less expensive on the world stage. While these tendencies produce opportunities trading currencies futures or in the spot market, exchange traded funds based on specific currencies also offers opportunities to spread.

ETFs on the U.S. dollar index and the euro currency are more than an ordinary pair of securities that have a predictable relationship. The Invesco DB USD Index Bullish Fund ETF (UUP) and the Invesco CurrencyShares Euro Currency ETF (FXE) have a negative correlation that may produce specific trading opportunities.

A chart of the UUP and FXE indicate that they are almost perfectly negatively correlated. The euro is one of several currencies whose price changes are inverted to those of the U.S. dollar, but the euro is the most powerful of these, having the greatest weight in the index.

There are several profitable trades suggested by this negative correlation. The trades depend on UUP falling in price with respect to the price of FXE over the first half of 2019. The UUP lost ground against the FXE in the first quarter of 2018, but surged past it in April 2018. Since that point it has gained more than 8% while the FXE has dropped nearly as much. Viewing a chart of the two ETFs, it is easy to imagine FXE and UUP as two lovers who embraced twice during the year 2018 and are eager to meet again in 2019. Spring and summer are made for romance between two currencies.

Just as the U.S. dollar is not independent, but is controlled by the inverse relationship with other currencies, the others are also not completely independent. For example, when one currency falls in price (either on purpose in order to improve its export trade, or due to a major geopolitical event such as with the British pound following the Brexit vote) other countries that are economic competitors also reduce their currencies’ prices in response.

Three currencies that are competing for low price are the Swiss franc, Australian dollar and the euro. Their combined weakness pushed the price of the U.S. dollar index higher in 2018.

In the international export-import business competing currencies force the U.S. dollar higher, a higher currency price is a distinct disadvantage for a country wishing to sell products on the world market. A relatively high price for the U.S. dollar benefits importers, such as American tourists traveling to Europe. For Americans producing goods for sale on foreign markets, it is bad for business.

In 2018 the Swiss franc, euro, and Australian dollar fell by 2.40%, 6.35%, and 10.11% respectively, while the U.S. dollar index increased by 7.66%. This means, for example, that U.S. export products increased in price by approximately 14% relative to the euro. This is equivalent to a tariff of 14% on U.S. goods exported to European countries. One way to counteract this difference is for the United States to apply a 14% tariff on imports from the other countries. These differentials are what the trade wars going on currently are all about.

To take advantage of the U.S. dollar and euro “mirror image” trade, consider buying puts on the dollar-based UUP ETF, and buying calls on euro-based FXE ETF. This is a classic reversion trade, with the UUP/FXE differential at its highest point over the last year. A time span of three-to-five months may see the two prices coming close together or actually meeting and crossing as they did between April and May of 2018. With this time frame in mind, an expiration date in June 2019 would be appropriate.

For the June 21, 2019, expiration date on Feb. 8, 2019, eight strike prices are listed for UUP puts ranging from $20 to $30, with a $25.72 closing price for UUP on Feb.  8.  Eighteen strike prices are shown for the June 21, 2019, expiration of FXE calls, ranging from $88 to $119 with a current price of $108.09 for FXE. While this spread has come in a touch in the early part of 2019, there is still a great deal of room to profit on a reversion to the mean trade.

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