by Darwin on September 23, 2009

Currency ETFs are starting to gain favor with retail investors as both a hedge to the weak dollar trend that has resumed since the flight to safety during the recent financial crisis, as well as for speculation.  While many individual investors are intimidated by setting up a Forex market trading account, there are several US Dollar ETF tools that allow American investors to hedge against both developed and developing market currencies.  The benefits of these individual hedges are numerous, but there are risks in trying to trade currencies as well.  Where many investors run into trouble is in using leverage to try and exploit a trend, but when that trend breaks, it can get ugly.  For investors and consumers that want to dip their toe in while providing some marginal hedging to a weak dollar crisis, ETFs are a much more practical and cost-effective means to achieve that objective.

Why Engage in Forex Currency Trading and Hedging?

Many Americans expend a considerable portion of their net income on energy and materials.  Since energy sources like oil and metals like gold and silver are traded on global exchanges as dollar-denominated assets, as the US dollar weakens against foreign currencies, while a particular commodity may remain roughly stable in terms of say, the Euro, it may become increasingly expensive in terms of the US dollar.  Consumers and investors looking to hedge this exposure on a grand scale can simply buy a currency ETF that provides returns based on the rise and fall of foreign currencies versus the US dollar.  All of the ETFs below are in terms of US dollars, so if you were to purchase FXA for example, youd be banking on an increase in the strength of Australias Dollar versus the US Dollar.  (If you were doing this over the prior 6 month period, you would have been right FXA is up over 20% as the dollar has weakened considerably against virtually all major currencies).

Some doomsayers are calling for an actual weak dollar crisis whereby China stops funding our debt, the Fed is unable to reign in inflation, unemployment remains high, the economy sputters, etc.  While buying Gold is one way to prepare for such a scenario, what if the current gold price already reflects such sentiment or if other factors like global demand suppress the rise in gold prices you were expecting?  At least with a foreign currency ETF, you get that gain no matter what, as long as you select the right currency.  For that purpose, most traders advise banking on a major currency versus the US like the Euro or Japanese Yen.  For the extreme risk takers out there, there are leveraged ETFs for currency as well.  (see full list of all sector and country leveraged ETF possibilities).

For creative traders out there, these currency ETFs actually provide the ability to trade options on the underlying instrument.  A creative way to hedge your currency and provide income to your portfolio instantaneously would be to purchase one of the ETFs below and then sell covered calls against the shares.  While this can start to become complex and eat into your funds with commissions, this article on how options work outlines some background, best practices and a comprehensive review of the best online brokers for such transactions.

Foreign vs. Dollar Currency ETFs Long, No Leverage

FXA      CurrencyShares Australian Dollar Trust

FXB     CurrencyShares British Pound Sterling Trust

FXC     CurrencyShares Canadian Dollar Trust

FXE     CurrencyShares Euro Trust

FXY     CurrencyShares Japanese Yen Trust

FXM     CurrencyShares Mexican Peso Trust

XRU     CurrencyShares Russian Ruble Trust

FXS     CurrencyShares Swedish Krona Trust

BNZ    WisdomTree Dreyfus New Zealand Dollar Fund

Leveraged Currency ETFs Long and Short