The Currency War Trader s Handbook

The Currency War Trader s Handbook

The Currency War Trader s Handbook Jim Rickards, Strategist, Shae Russell, Editor Currency wars are one of the most important dynamics in the global financial system today. A currency war is a battle about economic policy. The basic idea is that countries want to cheapen their currency. They say they want to cheapen their currency to promote exports. Maybe that makes an American company like Boeing more competitive internationally with Airbus, which is French. But the real reason, the one that s less talked about, is that countries actually want to import inflation. Take Australia for example. It has a trade deficit, not a surplus. If the Aussie dollar gets cheaper, it may make Australian exports slightly more attractive. It would also increase the price of the goods Australians buy whether it s manufactured goods, overseas holidays, textiles or electronics. That inflation then feeds into Australia s supply chain. So currency wars are actually a way of creating monetary ease and importing inflation. The problem is, once one country tries to cheapen their currency, another country cheapens its currency, and so on causing a race to the bottom. Of course, I started talking about this four years ago in my first book, Currency Wars. My point then was the same as it is today: the world is not always in a currency war, but when we are, it can last for five, 10, 15 and even 20 years. A BRIEF HISTORY OF CURRENCY WARS There have been three currency wars in the past hundred years. The First Currency War covered the period from 1921 to 1936. It really started with the Weimar hyperinflation. There was a period of successive currency devaluation. In 1921, Germany destroyed its currency. In 1925, France, Belgium and others did the same thing. What was going on prior to the First World War in 1914? For a long time, the world 1

had been on the classical gold standard. That means in a country s balance of payments, it paid for its deficit in gold. If you had a balance of payment surplus, you acquired gold. Gold was the regulator of expansion or contraction of individual economies. You had to be productive, pursue your comparative advantage and have a good business environment to actually get some gold in the system or at least avoid losing the gold you had. It was a very stable system that promoted enormous growth and low inflation. The world s great powers tore up that system in 1914 because countries needed to print money to fight the First World War. When the war ended and the world entered the early 1920s, countries wanted to go back to the gold standard but they didn t quite know how to do it. The great powers discussed the problem at a conference in Genoa, Italy, in 1922. Before the First World War, there was a certain amount of gold and a certain amount of paper money backed by gold. Then, the paper money supply was doubled. That left only two choices if countries wanted to go back to a gold standard. They could ve doubled the price of gold basically cut the value of their currency in half or they could ve cut the money supply in half. They could have done either one, but they had to get to some parity either at the new level or the old level. The French said, This is easy. We re going to cut the value of the currency in half. They did that. If you saw the Woody Allen movie Midnight in Paris, it shows US expatriates living a very high lifestyle in France in the mid-1920s. That was true because of the hyperinflation in France. It wasn t as bad as the Weimar hyperinflation in Germany, but it was pretty bad. If you had a modest amount of US dollars, you could go to France and live like a king. The UK had the same decision to make, but they made it differently to France. There, instead of doubling the price of gold, they cut their money supply in half. They went back to the pre First World War parity. That was a decision made by Winston Churchill, Chancellor of the Exchequer at that time. It was extremely deflationary. The point is, when you ve doubled the money supply, you might not like it but you did it, and you have to own up to that and recognise that you ve trashed your currency. Churchill felt duty-bound to live up to the old value. He cut the money supply in half and that threw the UK into a depression three years ahead of the rest of the world. While the rest of the world ran into the Great Depression in 1929, in the UK it started 2

in 1926. I mention that story because to go back to gold at a much higher price, measured in sterling, would have been the right way to do it. Choosing the wrong price was a contributor to the Great Depression. Economists today say, We could never have a gold standard. Don t you know that the gold standard caused the great depression? I do know that it was a contributor to the Great Depression, but it was not because of gold, it was because of the price. Churchill picked the wrong price and that was deflationary. The lesson of the 1920s is not that you can t have a gold standard, but that a country needs to get the price right. The UK continued down that path until, finally, it was unbearable, and they devalued their currency in 1931. Soon after, the US devalued the dollar in 1933. Then France and the UK devalued again in 1936. You had a period of successive currency devaluations and so-called beggar-thy-neighbour policies. The result was, of course, one of the worst depressions in world history. Unemployment skyrocketed. It crushed industrial production and created a long period of very weak to negative growth. The First Currency War was not resolved until the Second World War and then, finally, at the Bretton Woods conference in 1944. That s when the world went on a new monetary standard. The Second Currency War raged from 1967 to 1987. The seminal event in the middle of this war was President Nixon taking the US, and ultimately the world, off the gold standard on 15 August 1971. He did this in a bid to create jobs and promote exports to help the US economy. What happened? America had three recessions back to back, in 1974, 1979 and 1980. The US and Australian stock markets crashed in 1974. Unemployment skyrocketed, inflation flew out of control between 1977 and 1981 and it cut the value of the US dollar in half in just five years. Again, the lesson of currency wars is that they don t produce the results you expect. What you expect is increased exports, jobs and some growth. What they produce is extreme deflation, extreme inflation, recession, depression or economic catastrophe. This brings us to the Third Currency War, which began in 2010. Notice I jumped over the whole 23-year period from 1987 to 2010? What was going on then? That was the age of what we call King Dollar or the strong US dollar policy. It 3

was a period of very good growth, very good price stability and good economic performance around the world. It was not a gold standard system nor was it rulesbased. The US Federal Reserve did look at the price of gold as a thermometer to see how they were doing. Basically, the US said to the world: we re not on a gold standard, we re on a dollar standard. We, the US, agree to maintain the purchasing power of the dollar. You, our trading partners, can link to the dollar or plan your economies around some peg to the dollar. That will give us a stable system. That actually worked up until 2010 when the US tore up the deal and basically declared the Third Currency War. President Obama did this in his State of the Union address in January 2010. Here we are, and they re still continuing. That comes as no surprise to me. Many journalists will see something like the weak yen and say, Oh my goodness. We re in a currency war. And I ll say, Well, of course we are. We ve been in one for five years. And we ll probably be in one for five more years, or longer. Currency wars are like a seesaw they go back and forth and back and forth. In 2011, for example, we saw a very weak US dollar. We also saw a very high price of gold. That was the all-time high about US$1,900 per ounce. By 2015, the dollar got much stronger and gold came back down a lot. Here s what you need to know to keep track of this back and forth THE KEY TO UNDERSTANDING CURRENCY WARS: CROSS RATES Everything is a cross rate. There s an Aussie dollar/euro cross rate. There s an Aussie dollar/yen cross rate. There s an Aussie dollar/yuan cross rate, an Aussie dollar/swiss franc cross rate, and so on. They re very dynamic because the Aussie dollar could be going down against the euro, but at the same time it could be going up against the Chinese yuan. You can profit from these dynamics if you can understand them. Any two currencies are part of a zero sum game. That s something that confuses investors. They say, The Eurozone s falling apart. The euro s got to go down. That may or may not be true. But what investors miss is that the Fed wants the US dollar to go down too. The US dollar and the euro cannot both go down against each other at the same time. It doesn t work. Once you understand that cross rates are a zero sum game, then you can look at all of the cross rates effectively. 4

I think of gold as money, too, so I put gold into the cross rate mix. It s just another currency. The difference between when we re in a currency war and when we re not is stability. I don t mean that we have fixed exchange rates. We don t. We have floating exchange rates. But the central banks agree to keep their currencies within a certain range when the currency wars are off. When the currency wars are on, however, all bets are off. Anything can happen. They re very dynamic, very complicated and we will watch them very closely in Currency Wars Trader. We use unique models and nonconventional analysis to unlock the dynamics of the overall war apart from each day s battle report. There are a lot of ways for investors to win. But before you get started, it s important you understand how we ll aim to profit from these cross-rate dynamics in the weeks and months ahead. Your editor, Shae Russell, has more for you below Thanks for reading, Jim Rickards Strategist, Currency Wars Trader 5

Before You Read Your First Currency Wars Trader Alert Read On! By Shae Russell, Editor In your fortnightly Currency Wars Trader alerts, I will be recommending three separate trades within each alert. The expectation is that you choose the trade that s right for you. You don t have to implement all three trades in each alert. The three trade types to choose from will be: - Shares - CFDs - Options Each of these trade types has a different level of risk and reward. I ll spell that out for you in each trade. That way you can decide which trade idea makes the most sense to you for your individual circumstance. Let s go through each now HOW TO TRADE SHARES WITH CURRENCY WARS TRADER Using the Currency Wars share trading strategy can be easy. It s just like buying shares, but in the US market. You ll need to see if your current broker offers international shares. Most of the big online brokers do. If your broker doesn t, all four of the big banks do cover international shares. That means you can set up an international share trading account online with etrade, Westpac and Commsec. However it s worth nothing that at the moment, NABTrade has the cheapest brokerage costs. How long this lasts is anyone s guess though! All of their online platforms are easy to use. For more details, check out the guide, How to Buy and Sell International Shares in the special reports section of the Currency Wars Trader website. And by the way, for the purposes of our recommendations, we ll assume that your share trades are unleveraged. That is, you re not borrowing money to buy the shares. HOW TO TRADE CFDS WITH CURRENCY WARS TRADER Contracts For Difference or CFDs as you ve probably heard them called have become part of a standard trading strategy for the past 20 years. CFDs give traders the opportunity to participate in the performance of an underlying financial instrument without the need to ever buy it or sell it. 6

As the name suggests, a CFD is a contract for the difference between the price when you buy and sell a CFD of a share, index or commodity. Put simply a CFD is a contract between a buyer and a seller. The buyer and seller agree to exchange the difference between the prices of a share at the opening and closing of a particular trade. As stated by the Australian Stock Exchange (ASX), the difference is determined by a reference to an underlying asset a share, index, Forex or commodity and the period over which the CFD is held. CFDs are a popular financial tool because they give investors the ability to buy or a sell set amount of shares in a given stock, at a certain price for any period of time. There is no physical delivery of a CFD contract. You don t get the same benefits of owning shares, such as attending an AGM. But you do participate in dividends and any corporate actions, such as a bonus share scheme. UNDERSTANDING THE UNDERLYING ASSET The underlying asset is simply the basis for the CFD price. As I explained above, this could be a share, forex, Index or commodity. With CFDs you don t trade the physical asset, rather, a CFD mirrors the price of the underlying asset. A contract for difference is about trading for prices rather than buying into companies. Unlike some other financial products the price of the CFD mirrors the price of the share, index or commodity. It sounds complicated, but the reality is that it can be very simple. (Although, don t confuse simplicity with a lack of risk. As I ll explain in a moment, CFDs can be very risky.) There s a reason why CFDs are so exciting in monetary terms, compared to shares. The reason is: you do not have to hand over the full price of the share. Instead it s just a small percentage, say 10% although it can be as low as 1%. This makes it very exciting because the potential rewards are huge for a relatively small investment. But, with CFDs it s important to understand leverage and the risks LET S BE VERY CLEAR. CFDS CAN BE A HIGHLY LEVERAGED INVESTING TOOL. By using leverage it allows you to trade on the rise and fall of shares and other assets, without stumping up all the cash. Basically, when you open a CFD position you pay a small amount up front a deposit and then the rest of the position is covered using leverage from a CFD provider. 7

This means, in any CFD trade you get the same losses or gains as if you owned the physical share. However because you pay only a fraction of the trade price up front, the gains and losses can be much greater. With some types of CFDs such as a CFD over an index your leverage can be as high as 99 to 1. In other words, to open a CFD position, you can put down as little as 1% of the value of the trade as a deposit. The other 99% is covered by the CFD provider. For example, if you were to open a CFD trade on the ASX200, with a current value of 5,100, with CFDs you would only be required to place a deposit of $51 to open the trade. The other $5,049 is the leverage the CFD provider uses to open the trade for you. RIGHT HERE IS WHERE I NEED YOUR ATTENTION. Leverage is a fantastic tool. It allows you to access many types of markets and trades. However, it s a double-edged sword. Remember before when I said you could leverage as much as 99 to 1? While that s possible, my advice is not to do it. Seriously, using that sort of leverage is the quickest way to losing all your money. Here s why. When you open a trade you only put down a measly deposit. And the CFD provider makes up the rest. But guess who s responsible for the full position? That s right, you! At any given time, you need to make sure you have enough cash to be able to cover the position should something go wrong. That is, if the CFD trade goes against you like when you re facing a loss the CFD provider will make what s called a margin call. This is simply an email or phone call to ask you to top up your account to cover the loss. I can t emphasise this enough. At no point, should you ever EVER open a trade you can t reasonably cover at least two thirds of. What I m suggesting is that when you trade CFDs you have a maximum of a 2 to 1 mentality. That is, rather than being leveraged to the eyeballs, keep it sensible. Using 2 to 1 means you re reducing your liability in case the worst happens. Of course the final decision is up to you. But all our examples will be on the basis of 2 to 1 leverage. And get this! The worst CAN happen with leverage. So always be prepared by keeping your leverage low. 8

Let s have a look at an example so I can show you how it works. We can use the XJO. Say for example it s trading at 5,100. And you want to buy five contracts. That would bring the total value of your position to $25,500 (five times 5,100). Now, if you re leveraging 99 1 (1% value of the trade), you only need $255 to open a long trade on the XJO. Doesn t that sound crazy to you? A couple of hundred bucks for a $25,000 position. It is crazy. That s why we suggest a maximum of 2 to 1 leverage. Again, you buy five XJO contracts at 5,100. It s still a $25,500 position, but by only being leveraged 2 to 1, your initial deposit is $12,750. This way, your gains won t be as big in comparison to using more leverage; however it s a far more sensible approach to trading with a leveraged instrument. Look, I m not trying to put you off CFDs by highlighting the risks. On the contrary. CFDs are a fantastic trading tool. They enable you to open positions that you might not be able to otherwise. But you need to understand the risks associated with them very carefully. By using minimal leverage CFDs are a great way to trade the currency wars. By the way, to understand all the risks associated with CFDs make sure to check the product disclosure statement (PDS) issued by your CFD provider. It will contain all the risks, features, and details applicable to trading CFDs. HOW TO TRADE OPTIONS WITH CURRENCY WARS TRADER The final strategy will involve buying options on US-listed stocks. Now, before you react to the term options hear me out. Options sound complicated, but they aren t once you understand how they work. It s true that options give you a lot more leverage to a stock as opposed to buying shares outright. They re much more volatile too. And it s also true that while they have much more upside, you can lose all of the money that you put up to buy them. But used properly, options are a great way to make outsized gains in the markets. In the following pages, I m going to tell you everything you need to know so you can act on our Currency Wars Trader recommendations using options if that s the strategy you choose. 9

You ll know what you re buying or selling the risks and profit potential involved and your next steps. Let s start at the beginning. WHAT YOU NEED TO KNOW ABOUT OPTIONS An option is a financial instrument that gives you the right but not the obligation to buy or sell a specific underlying financial instrument at a specific price within a set period of time. I want you to reread that sentence slowly and carefully, at least three times, out loud. It tells you everything you need to know about how an option works. Financial instrument means something you can buy and sell. Once you buy an option, you can resell it to another investor for a profit or loss. Also, notice that options give you a right not an obligation. That is, you choose whether you want to exercise that right. An option gives you the right to buy or sell a specific underlying instrument but not both. When you buy the option, you must choose whether you expect to profit from a rise or profit from a fall in the price of the underlying stock. If you expect the stock to rise, you buy what s known as a call option. If you expect the stock to fall, you buy a put option. Every stock option no matter what stock it s over allows you to control a fixed number (usually 100) shares of stock. Unlike when you buy stocks, however, buying options limits your risk. You lose only the amount you paid to buy the options. And your profits are practically limitless. THE ANATOMY OF AN OPTION For our example, imagine I recommend that you buy to open the Microsoft Corporation [NASDAQ:MSFT] December 2015 $48 call option up to $1 per contract. Here s the breakdown of how that would work. All options contracts have certain things in common. The most important is the expiration date. 10

Every option expires on a set date, which you know before you buy the contract. Past that date, the option becomes worthless and the rights to buy or sell the stock that the option gives are no longer valid. You ll also have a strike price for every options contract. This is a fixed price for the life of the contract. Say the underlying stock trades for $45. A put option strike price of $48 would allow you to sell 100 shares at $48 a pop $3 higher than what the stock trades at. WHAT DOES BUY TO OPEN MEAN? All buy to open means is that you are opening an options trade by buying a call or put. Once your trade is executed, the call option shows up in your brokerage account. From then on, it will fluctuate in value up and down. Over time, we will send you an email alert to take profits (or cut losses) by selling to close the option. Selling to close will close the trade, and your broker will deposit the cash proceeds from selling the option into your account. It s important to note that in Currency Wars Trader, we will only make two types of options orders: buy to open and sell to close. WHY USING OPTIONS CAN AMPLIFY YOUR GAINS Say you think Company XYZ s stock will go up significantly in the next few months. You have two ways to profit if you re right: you can buy the stock outright and hope it goes up or you can buy a call option on that stock. As we talked about earlier, each call option typically controls 100 shares of stock. And each call contract has two unique elements: an expiration date and a strike price. An expiration date is exactly what you think it is. If you don t exercise your option before the expiration date, it expires and is worthless. A strike price is the price at which you can exercise your option. The difference between the strike price and that of the underlying stock is called intrinsic value. In our last example, the underlying stock trades for $45. A put option with a strike price of $48 means you d have the right to sell that $48 stock for $48 so, it would have an intrinsic value of $3. In the same way, a call option with a strike price of $41 means you have the right to buy that $45 stock for just $41, so it would have an intrinsic value of $4. Intrinsic values go up and down as the underlying stock goes up and down. Exercising a call option is simply choosing to enact your option to buy shares at the strike price. If the strike price is higher than the current price of the stock, you don t want to 11

exercise your call option. After all, why would you want to pay more for a stock than you have to? As the buyer of an option, no one forces you to exercise your option. That s why we call it an option. If the underlying shares are trading higher than the strike price when you exercise a call, you ll typically collect 100 times the difference between the two prices. For instance, using the call option example, if you ve bought one contract, covering 100 shares, and the share price is $3 above the strike price, you ll make a profit of $300 (100 times $1). If the shares are worth less than the strike price at expiration, you lose your premium. Here s how we re seeking to make trading profits. We won t be holding options until expiration, and won t be exercising them. Our trades are simple buy/sell propositions, just like buying and selling a stock. We will send you email alerts to sell your option before it expires. This brings us to the premium. That s the fee you pay the seller for the call or put. The fee for option contracts that the buyer pays to the seller can vary wildly. Sometimes, depending on how many contracts you wish to buy, it can be as low as $100. Sometimes, it can be as high as thousands of dollars. That s because the fee of each option what we call the premium is comprised of three factors: stock price, time decay and volatility. You don t have to understand how these factors work. I m telling you about them just so you have a basic understanding of what determines the fee. Our recommendations can make money in several ways, including a jump in intrinsic value and a jump in implied volatility. As the underlying stock price rises, the intrinsic value of a call option rises at a faster rate than the stock. Conversely, as the underlying stock falls, the intrinsic value of a put option rises at a faster rate than the stock. If the volatility of the underlying stock spikes, the value of both puts and calls increase. HOW YOU CAN OPEN A US OPTIONS TRADING ACCOUNT For an account where you can buy and sell US exchange traded options, you ll need to fill out a form with a stockbroking firm that offers US options trading. Call your existing broker first. If they don t provide this service, find one that does. I ll show you a list later on. Once you find a broker that offers US options trading, the broker should provide you with an options account application form. It will ask a few questions about your financial situation, investment background and what your interests are. 12

Be sure to read and understand all of your broker s terms and conditions, and tick the boxes that say, buying calls and puts. This is usually one of the lowest clearance levels for options trading. You won t need to get clearance for more complex options strategies. Your broker should help over the phone if you have any questions. Once you submit this form, your broker should typically give you approval and activate your account within two or three business days. Unfortunately, we can t give specific broker advice. (It s a legal thing.) But we can point you in the direction of a few brokers you might consider using. You should be able to use these brokerages to handle your shares and options purchases and sales. Make sure you do some of your own research on these brokerages to find the one that best fits your needs. Here are three of the main players that deal with options trades on the US market: - OptionsXpress 1300 781 132 - Interactive Brokers 02 8093 7300 - Halifax Investment Services 1300 363 505 AN IMPORTANT NOTE ON RISK MANAGEMENT We re not going to be recommending specific percentages of your portfolio that you should allocate to each options play. Nor will we make general recommendations about what portion of your portfolio you should allocate to trading options. It s extremely difficult to give advice on this without knowing the specifics of each individual investor s circumstances. This is especially true in buying options. If these plays work out, you could make 300% or more in some cases, but if we re wrong you ll lose 100% of the option premium, which may be worse than going down 20% or even 50% on a single stock. It s important to maintain some cash and liquidity at all times. Do not put all of your money into these plays. It s important that you diversify your wealth across stocks, fixed income, hard assets and cash. Jim believes deflation and inflation are both dangers today. Be prepared for either or both with a balanced portfolio. Consult with your broker, lawyer, accountant and tax adviser on any important financial decision. Investing is risky, volatile, and frequently speculative. Do not invest more in any one position than you can afford to lose. 13

TRADE EXAMPLES Before I finish, let me take you through some trade examples to show you the potential gains and losses from a trade. Remember, each Currency Wars Trader alert will come with three trade choices: shares, CFDs or options. Each has a different risk profile. Each has a differences relating to maximum gains and maximum losses. Maximum Gain Maximum Loss Shares Unlimited 100% of your investment CFDs Unlimited The amount of the underlying exposure. This may exceed the amount you deposited in your CFD account Options Unlimited The amount of the premium paid Now let s look at a trade example and the possible outcome. Trade #1: Action to take: Buy XYZ Ltd shares for $20 per share If you buy 100 shares, it would cost you $2,000. Your maximum gain is unlimited. If the shares go to $40, your investment would be worth $4,000. That would be a 100% return on your investment. Your maximum loss is the $2,000 you invested. Trade #2: Action to take: Buy XYZ Ltd CFDs for $20 using 2:1 leverage If you buy 100 CFDs, you would allocate $1,000 from your CFD account, but you would have exposure to $2,000 worth. Your maximum gain is unlimited. If the shares go to $40, your investment would be worth $4,000. That would be a 300% gain on your investment. (You used $1,000 to achieve this leveraged gain.) Your maximum loss is $2,000. This exceeds by $1,000 the amount you allocated from your account. You have made a 200% loss on this investment. This is the doubleedged sword of leverage. Trade #3: Action to take: Buy XYZ Ltd Call Options with a strike price of $20 for $1 per share If you by one contract (each contract covers 100 shares of stock) it will cost you $100 (100 times $1). 14

Your maximum gain is unlimited. If the shares go to $40, your investment could be worth $2,000. ($20 times 100 is $2,000.) That would be a 1,900% return on your investment. Your maximum loss is $100. This is the amount you paid for the call option premium. Now, you may think that options are always better than the other choices because the dollars at risk are less. That s partially true. However, options expire. If the share price and therefore option price doesn t perform as you expect within the set timeframe, you would still lose. That s compared to stocks and CFDs, which don t expire. So for instance, you may bet on XYZ Ltd rising by December, and so you buy the December call option. But, if the share price doesn t move by December your call option could expire and be worthless. On the other hand, if the share price begins to move in January, your stock and CFD positions would benefit from that move if you stay in the trade with the stock and CFD. I hope that helps you understand the risks and potential reward for shares, CFDs and options. Each have their own risk and reward profile. One isn t necessarily safer or riskier than the others. It all comes down to how you use them, the amount you invest, and the timeframe involved. That s all we have for you! If you have any other questions, feel free to email us at: CurrencyWarsTrader@ portphillippublishing.com.au Otherwise, please be on the lookout for your first twice-monthly alert in your inbox. Regards, Shae Russell, Editor, Currency Wars Trader Warning: While useful for detecting patterns the past is not a guide to future performance. The value of any investment, and the income derived from it, can go down as well as up. For any investment, never invest more than you can afford to lose, and keep in mind the ultimate risk is that you can lose whatever you ve invested. While useful for detecting patterns the past is not a guide to future performance. Some figures contained in this report are forecasts and may not be a reliable indicator of future results. All advice is general advice and has not taken into account your personal circumstances. If in doubt of the suitability of an investment please seek independent financial advice. Please download and read our Financial Services Guide: http://portphillippublishing.com.au/financialservices-guide/ Jim Rickard s Currency Wars Trader is published by Port Phillip Publishing Pty Ltd. Registered Office: Port Phillip Publishing Ltd Pty, 96-98 Bridport St, Albert Park 3206 Port Phillip Publishing (ACN: 117 765 009) (AFS Licence: 323 988). All content is 2015 Port Phillip Publishing Pty Ltd. All Rights Reserved. cs@portphillippublishing.com.au 15