As the number of currency ETFs available grows (along with retail involvement), there are a number of common mistakes traders should be aware of before jumping into these investment vehicles.
Currency ETFs are attractive because they offer diversification benefits in stock portfolios, and offer easy access to the foreign exchange market, all without requiring a forex account. To take full advantage of these funds, avoid the common mistakes outlined below.
Be sure to also see the 5 Tips ETF Traders Must Know.
1. A Popular Currency Doesn't Mean a Popular ETF
There are a growing number of currency ETFs, though most are not heavily traded. Just because an ETF is based, for example, on the euro, Great British pound or Japanese yen (all popular currencies), doesn’t mean the fund itself is popular or actively traded.
Volume, the number of ETF shares changing hands in a day, allows traders to buy and sell at will knowing they are getting an efficient price based on current conditions. Always check the volume of an ETF and favor funds that trade more than 100,000 shares per day.
If holding for the long term, consider funds with 20,000 or more in daily volume. For active traders, only trade ETFs with at least 500,000 in daily average volume.
See ETFdb.com’s full List of Currency ETFs.
2. Not Anticipating Almost Constant Price Gaps
The currency market is not centralized, trading 24 hours a day from Sunday night to Friday evening. During the week, various parts of the world are always open for business, meaning that currency prices do not stop fluctuating during that time. Most currencies see increased movement during the European session which continues into the American session.
ETFs trade during stock market hours. Each night, currencies move and ETFs adjust in the morning to reflect the new prices. This means there are constant price gaps. Price gaps make it difficult to precisely control risk with a stop loss, since the price could gap through the stop loss price over night, resulting in a larger loss than anticipated. Investors may also earn more than anticipated if the price gaps through their target price.
When trading currency ETFs, give the trade plenty of room. Risk should be controlled, but if holding overnight don’t place a tight stop loss (very close to the current price). Currency ETFs are ideally suited to longer-term trades (a couple of months or more), or day trading where positions are closed each day.
3. Assuming One Factor Drives a Currency
It would be unwise to assume that the same fundamental factors will always affect related currencies in the same way. For example, the Canadian dollar and the price of crude oil are correlated. If oil drops, the Canadian dollar tends to drop as well, and vice versa. Figure 1 shows the long-term correlation. The two do tend to move together most of the time, but not always.
A prime example of this point occurred in early 2008. Oil was skyrocketing but the CurrencyShares Canadian Dollar Trust (FXC) drifted lower. In late 2009, oil, as represented by OIL, was plummeting but the Canadian dollar stabilized well before the oil low. Since 2009, oil and the Canadian dollar have followed roughly similar paths, though oil is more volatile and the two don’t always move in perfect unison.
Correlations like these are not strong all of the time, though they may be useful. Investors would do well to focus on the price action of the currency ETF as opposed to searching for external causes and effects. When trading a currency ETF, determine entry points, risk, and exits based on the price chart, not on perceived or actual correlations.
See also the 3 ETF Trading Tips You Are Missing.
4. Thinking of New Currency ETFs as "IPOs"
Currency ETFs are based on the value of an underlying currency which has been trading for a long time prior to the introduction of the ETF. While the value of an ETF may trade at a premium or discount relative to the underlying asset for a short time, it would be unwise to buy an ETF product just because it’s new or provides access to a foreign currency.
ETFs offering access to emerging-market currencies may seem appealing, but investors should consider whether or not the underlying currency is a good investment. For example, Iraqi dinars became very popular following that war, but that they became readily available in the West doesn’t mean they were a good investment. Always focus on the underlying value and the price trend; trade in the direction of the trend.
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5. Underestimating the Persistence of Trends
Currencies tend to move in long-term trends that typically persist for multiple years. While currencies are driven to a large degree by speculation, they are also driven by the economic health of a country, its outlook, and the global demand for its currency. Economic cycles take years to move from peak to trough, hence the long-term trends in currencies.
If holding for the long term, minor fluctuations need not scare investors. What looks like a reversal on a daily chart will often simply be a pullback on the weekly or monthly chart. Define an exit plan before making the trade.
6. Always Needing to Be in a Position
Traders and investors need not be in trades at all times. There are times when an investor might not know what to do, or conditions are too volatile for comfort. In such cases, investors should avoid the compulsion to trade. It’s best to wait for setups worth trading. No setups, no trade. Prices are always moving, meaning there’s always an opportunity to get in, whether it be in a different currency ETF or in the same one when another trade setup develops.
Be patient in waiting for trades, and then be quick to act when the right setups occur.
For traders looking to hold a position for several months or more, Figure 3 shows how one could potentially look for times to trade and times to avoid trades (new positions) based on support and resistance areas.
7. Not Considering Expense Ratios and the Bid/Ask Spread
Fees come in multiple forms. The easiest to spot is the expense ratio. As a general rule, a lower expense ratio is better. But if one fund outperforms another similar fund, then paying a higher fee may be worth it. For example, as of March 4th, 2015 UUP was up 5.84% YTD, while USDU was up 3.8% YTD. Both funds track the U.S. dollar. Based on this, paying the 0.80% fee for the former may be better than paying the 0.50% expense of the latter.
However, it’s also important to keep in mind that expense ratios don’t usually change, while performance can: one fund may not outperform the other in the next month.
Be sure to see our list of the Cheapest ETF for Every Investment Objective.
The bid/ask spread is also an important consideration point. The wider the spread (the distance between the bid and ask), the harder it is to get a favorable price, especially if using market orders. If there is a large spread to be crossed in order to buy or sell, then investors are not getting an efficient price. This brings us back to our first point: gravitating towards ETFs with higher volume, as they typically have the tightest spread. Whenever possible, use limit orders to get the best price available, as opposed to using market orders.
The Bottom Line
Currency ETFs offer great diversification benefits and easy access to foreign currencies. All traders and investors should be aware that currencies tend to trend; dominant trends last multiple years, and even pullbacks against the trend can last many months. Don’t get too drawn into looking for external events or correlations to dictate what a currency will do. Wait for entry points, and plan trade exits in advance. Lastly, remember to use limit orders to help get the best price possible, as opposed to always using market orders.
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Disclosure: No positions at time of writing.