ETFs and forex trading

Futures, Feb 2008 by Cofnas, Abe

One of the important questions for 2008 will be whether the downtrend in the dollar will continue or change. The forex traders that succeed in picking a bottom in the dollar will reap significant rewards. Whether the November low will hold is questionable, but the housing crisis in the United States appears to be spreading so some dollar recovery - even by default - may be likely.

A fairly new set of trading and diagnostic tools in the form of Exchange Traded Funds (ETFs) are now available to the forex trader. ETFs are becoming an important asset category and provide investors and traders wirh new opportunities to participate in targeted markets. For the forex trader, ETFs can be used to derive supportive information about the direction of currencies. Many ETFs also offer options providing even more potential for shaping trades. ETFs that are related to currency trading include dollar sentiment ETFs, ETFs on economic sectors (housing, real estate, etc.), ETFs tracking currency pairs and ETFs on commodities. All of these categories can help the forex trader in deciding direction, especially ETFs that track dollar sentiment.

The forex trader can use the Powershares DB U.S. Dollar Index Bullish Fund (UUP) to detect a shift in the dollar sentiment. UUP employs a bullish dollar strategy. The ETF is long the dollar against several currencies including the euro, yen, British pound, Canadian dollar, Swedish krona and Swiss franc. Obviously this has not been a profitable fund recently, but this ETF can indicate the mood of the market. Changes in its price will alert the forex trader when there is a shift in dollar sentiment. In contrast the Powershares U.S. Dollar Index Bearish Fund (UDN) is an ETF with a bearish strategy.

An effective way to use these ETFs is not necessarily to trade them, but rather to evaluate their relative performance. UUP and UDN are a good pair to look at because they are nearly perfectly negatively correlated at -0.96 (see "Dueling dollars"). Comparing these two sides of the coin on U.S. dollar sentiment is an effective way of deriving further insights.

If the forex trader wants insight into whether dollar bearish sentiment is likely to continue or may be near a bottom, generating a spread chart between these ETFs would identify whether the bulls or bears are at extremes. If the spread is at the widest point, it is likely to narrow. If the spread was narrowing, then it likely will widen. This likelihood is based on standard deviation analysis.

So what happens when we spread these two different funds (see "Bottom dollar")? We see the status of the spread at the close of the year was 3.88. The spread between the bull and the bear ETFs was in its 83.56 percentile. This means that an eventual narrowing of the spread is likely and could become a leading indicator for a shift in sentiment from the current bearish downtrend to neutral territory.

At its highest, the spread was 5.25, at the lowest it was -0.19. Being at 3.88 means that it is in its outer part of the statistical bell curve. Another point of alert occurs when the spread hits the center of the curve at the mean (1.9756). This would show a relative balance between the bulls and bears and could indicate a breakout in either direction. This occurred in July prior to a minor correction, in August prior to a larger dollar correction and in September, just prior to the dollar breaking through a double bottom support area. Of course, when this will occur is not known, but the signs will become discernable if the forex trader knows where to look. The ETFs may very well prove to be a leading resource for shaping forex trades into 2008.

Abe Comas is president of leamfexom LLC and author of The Forex Trading Course: A Self-Study Guide To Becoming a Successful Currency Trader (Wiley Trading). E-mail: learn4x@earthlink.net.