Short U.S. Dollar: How Crowded is This Trade?

Pete, December 14, 2007 @ 2:50PM ET | Link | RSS | Read via Email | Start a Discussion  

Earlier this week, Simon Constable admonished readers at TheStreet.com that if “you have to catch something that’s going around, do whatever you can to make sure it’s not the forex trading bug.”

Fear the Forex Market
Although the offers of easy riches from swapping currencies might be tempting, the vast majority of investors would do well to resist the lure. Not only is this market supremely risky, but there are other, better ways to achieve the same investment goals.

That’s not readily apparent to everyone, especially given the feeble performance of the U.S. dollar, which is down around 30% against the euro over the past five years. That has made betting against the greenback look like an appetizing one-way bet.

As the easy money of the housing market becomes a distant memory, a small industry of shops offering fast access to the forex market has sprung up like mushrooms in a dark, damp room, all hinting at the profits to be made by trading currencies.

I tend to agree with his sermon, and would emphasize that leverage is the real killer. While hedge funds go bust left and right at 20X leverage (5% move against the position = wipeout), most newbie FX traders employ 100 - 200X leverage, resulting in a 45-day average life expectancy:

How Leverage Affects The Individual Trader
It may be quite challenging to find a trading method or system that can handle 1:100, since the account can never be down more than 1% without bankruptcy. The 1% also has to be divided into smaller chunks, say, 10, to accommodate a potential string of losses, meaning that each trade can never be down more than 1/10 of 1 percent. That is an awfully small.

Leverage aside, there is still the question of this: if everyone in the world is already short, how much more downside is there?

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I ran the Rydex CurrencyShares against the U.S. Dollar index using a three-month window. From the looks of it, the rise of a large number of currencies against the U.S. Dollar — the Aussie Dollar (blue), British Pound (cyan), Canadian Loonie (red), Euro (green), Japanese Yen (powder blue), Mexican Peso (magenta), Swedish Krona (grey) and Swiss Franc (dark magenta) — happened in tandem. We’ve already seen spike tops in some of these, so when when the dollar reaches a tradeable bottom, there is good reason to expect a doozie of a short-covering rally.

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