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By Jason Pearce

The Two-Edged Sword

Archimedes made a great statement about the power of leverage when he said, “Give me a lever long enough and a fulcrum on which to place it, and I shall move the world.”  That’s a great quote…until it gets misapplied to the arena of speculation.  Context is everything.

If you’re gonna talk about the advantage of using leverage in the financial markets, you would be irresponsible if you didn’t address a subject that’s intrinsically linked to it: risk.  If you want to learn the correct way to use leverage, you need to consider more than just the potential gains that leverage can bring.  You have to consider the potential losses.

The pros know that the winners take care of themselves.  It’s the losers that have to be managed.  The problem is, too much leverage can make the losing trades unmanageable even if you’re actively protecting yourself with stop orders.  Leverage is the how the markets provide a trader with more than enough rope to hang himself.

Leverage Levels

Currently, a stock brokerage firm will allow customers to trade with leverage of 2-to-1.  This is done by providing a margin loan to the trader.  If a trader has $100,000 on deposit, the brokerage firm will loan him up to $100,000 and allow him to buy $200,000 worth of equities.

So a stock trader with margin could double his money on a stock that increases in value by 50%…and just as easily wipe out his stake if the price of the stock was cut in half.

Many people believe that trading commodities is far riskier than trading stocks.  What?!  Trading corn is riskier than trading Tesla?!  This notion was likely brought about by the fact the available leverage for commodity trading is significantly higher than the leverage for stocks. So the belief is half right; commodity trading can be risker, but that’s because of the leverage available, not the instrument being traded.

That margin requirement to trade a futures contract is often around 5% of the value of the underlying contract.  For instance, the E-mini S&P 500 is currently worth around $120,000.  The initial margin requirement is $5,500, which is just 4.5% of the contract’s value.  This would allow a futures trader to potentially leverage his account at a level of 20-to-1 where $100,000 on deposit can control as much as $2 million worth of futures contracts.

At a level of 20-to-1, a fully margined commodity account would make a fortune on a modest price increase.  The other side of that coin is that the trader could also be completely wiped out on a 5% adverse move in price.

Forex trading reaches a whole different level of leverage…and insanity.  Those sleazy online “bucket shops” that are always trying to sucker the public into currency trading offer traders leverage of 50-to-1…and 100-to-1…and sometimes even 200-to-1.

Just think about that in dollar terms.  A $100,000 deposit in a forex account could control $5 million, $10 million, or even $20 million worth of currency.

At 100-to-1 leverage, it only takes a 1% change in price to double you money or lose it all.  What could possibly go wrong?

Too Much of a Good Thing

Just as leverage can amplify investment gains, it also amplifies invest losses.  This is why you never see professional traders and money managers taking full advantage of the leverage being offered.

It’s also why you’ve never heard of a professional trader racking up a month or even a year with a +1,000% return.  To knock it out of the park like that, you’d have to take way too much risk.

As a matter of fact, one professional trader I know gets very concerned if he makes too much money over a certain period of time!  His thinking is that he must be taking on too much risk or using too much leverage if the gains are accruing that quickly.

Professional traders make their trades based on probabilities.  But they manage risk based on possibilities.  If it’s possible for profits to snowball quickly, then it’s possible for losses to snowball quickly as well.  To keep a losing streak from turning into an avalanche you’ve got to put limits on the amount of leverage used.

Bond Bubble Blowup

C.S. Lewis wrote, “Experience: that most brutal of teachers. But you learn, my God do you learn.”  I’ve had the pleasure of having Professor Experience personally tutor me when I attended the University of Hard Knocks.  My major was in What Not to Do When Trading.

Let me first say that mean reversion works…eventually.  But if you’re going to make a bet on it and hold on, the trick is to make sure your position is small enough to survive the waiting period.  The more leverage involved, the less staying power you have.

When I was a wise old trader in my twenties, I picked a fight with the bond market.  Confidence and hubris was running high because I’d just come off of a couple of successful trade campaigns in the grain market and the Japanese yen.  And now that the Treasury market was running away to record highs, I put them in the crosshairs and went short.

T-bonds were around 124-00 at the time, which is a value of $124,000 per contract.  So initially, I went short one contract for every $20k in account equity and figured I could safely hold a contract with a $20k cushion and ride out the storm without needing a protective stop.  Based on the contract value, I was leveraged at 6-to-1.

T-bonds just kept ripping higher and posted a record string of daily gains.  Three weeks after I went short, I experienced an intraday drawdown of a little over $5,500 per contract.  Perversely, my losses were ratcheting higher by the day while the probabilities of a reversal also increased.

But don’t confuse probable with possible.

The six-figure open loss caused me emotional turmoil.  My $20k cushion shrank to $14,500 per contract.  I was down, but not out.  But I now had a bond contract value of $129,500 with a cushion of $14,500, raising the leverage to nearly 9-to-1.

Out of the Frying Pan

I called up another “professional” trader I knew in order to get his take on things.  He asked me about my conviction on the trade.  I told him I was still bearish and bonds just had to crash after a run-up like this!  Somehow, an old floor trader saying popped up: “When in trouble, double”.

So I did.  Seriously, I was already bleeding with a six-figure loss and then I proceeded to double my exposure by selling more contracts short at 128-24 ($128,750 value).  By doing so, my equity cushion was suddenly $15,250 for every two contracts.  Two contracts at that price are worth $257,500.  That spiked the leverage on the position to nearly 17-to-1.

As you would expect, Treasuries only accelerated from there.  The market posted daily gains and even some new all-time highs for several consecutive trading days.

When my trading accounts were just a stone’s throw away from a margin call, I finally tapped out.  I lost about $9k for each initial short contract and another $4,250 for each ‘add-on’ short contract.  My attempt at The Big Short wiped out two-thirds of my equity ($13,250 for every $20k), meaning a total loss of several hundred thousand dollars on the books.

Oh, and it gets even better…

As fate would have it, I covered all of those short positions just one day before the final record high was set!  Bonds tanked the very next day and started the multi-month decline I was anticipating…but without me in it.

There are a lot of lessons to learn from this story: Don’t bet the farm on one big trade, don’t fight the trend, don’t trade without protective stops (or at least options to hedge), don’t depend on the opinions of others, etc.

But one lesson I want to bring highlight right now is that of using too much leverage.

Had I stuck with the original (flawed) plan, which was a fully leveraged position of 6-to-1, I would have still had to endure a wicked drawdown.  But I would have never been forced to choose between liquidating or meeting a margin call.

By adding to a losing position and tripling my leverage to nearly 17-to-1, my protective buffer of equity was removed.  I had no more wiggle room when the trade went further against me and I had to get out.

Bottom line: the amount of leveraged used was the only difference between being able to weather a major drawdown until I could eventually get out with a profit or being forced out early with major losses.

Miscalculating Risk

I stated earlier that too much leverage can make the losing trades unmanageable.  A lot of times, this is due to the false sense of security that protective stops can bring.  You may think you know what your risk on a trade is, but sometimes you can be wrong.  Very wrong.

Suppose Sensible Sam is watching the soybean market and he thinks it’s about to take off.  He has $100,000 in his account and wants to risk three percent of his equity on a soybean trade.  That means he’ll have to put a protective stop order in the market to knock him out if the market moves against him by $3,000.

So Sensible Sam goes long three 5,000 bushel soybean futures contracts at $9.98 and places a protective sell stop at $9.78, which is twenty cents ($1,000 per contract) below his entry price.  Although he’s risking just three percent of his equity, Sensible Sam is moderately leveraged at about 1.5-to-1 because he has actually purchased $149,700 worth of soybeans ($9.98-per-bushel x 15,000 bushels = $149,700) with his $100k account.

Along comes Gunslinger Gary.  He’s also looking at the same soybean market and wants to get in on the action.  He’s been burned before by risking way too much of his equity, but he still wants to capitalize on the expected move in beans.

Gunslinger Gary has a brilliant idea: buy a ton of contracts and set a really tight protective stop.  Perhaps he is even going to follow Sensible Sam’s lead and risk just three percent of his $100,000 account…but that’s where the similarities stop.

Gunslinger Gary buys twenty 5,000 bushel soybean futures contracts at $9.98 and places a really tight protective sell stop at $9.95, which is just three cents ($150 per contract) below his entry price.  Theoretically, he’s only risking three percent of his equity.  However, trouble is brewing because Gunslinger Gary is leveraged at 10-to-1.  He has actually purchased $998,000 worth of soybeans ($9.98-per-bushel x 100,000 bushels = $998,000) with his $100k account.

Maybe Gunslinger Gary’s protective stop placement actually makes sense because he’s using intra-day charts to time a quick exit.  That’s not what I’m concerned about.  But we can’t escape the fact that he’s substantially more leverage than Sensible Sam.

Let’s forget about the best-case scenario where beans go ripping higher right after these guys get in.  Consider what happens if the market drops instead.

What if Gunslinger Gary’s protective stop is elected and he gets three-cent slippage on the fill?  He’ll lose $6k instead of $3k.  That’s double what he thought the risk was.

Or what if he manages to stay in the trade but an adverse crop report hammers the beans down 20 cents in the afterhours market where slippage is even greater or beans gap down in the morning (if he’s using pit-session stops only)?

In this scenario, Sam would also get knocked out of his three soybean contracts and suffer the $3k loss.  But good ol’ Gunslinger Gary would get murdered.  The 20-cent loss on his twenty soybean contracts would cost him a whopping $20,000.  That one trade would wipe out one-fifth of his account.

Although I used a hypothetical scenario to show the damage that leverage can inflict on a losing trade, don’t think for one moment that it’s not a plausible scenario.

Ask anyone who’s ever traded grains in the summer or had a position on when a crop report came out and you’ll hear tales about the market instantly moving limit.  Sometimes, the market will even move lock limit.  If you’re on the wrong side of that move, it means you can’t even get out at the market price!

Currently, the CME set the limit for soybeans at 70 cents ($3,500 per contract).  That limit amount can get raised by 50% in a heartbeat.

The takeaway here is that leverage is just as important –maybe even more so- than protective stop placements when calculating your true market risk.  Yes, you should have protective stops.  But you should also have leverage limits.  Leverage is like medicine: a little bit can help you…but too much will kill you!

Highly-Leveraged Is Relative

Most traders have heard the famous story about how George Soros “broke the Bank of England” by betting against the British pound back in 1992.

Soros’ right-hand man, Stanley Druckenmiller, was the one that pitched Soros the idea of shorting Sterling.  Druckenmiller said that Soros taught him to “go for the jugular” when you have a very strong conviction on a trade and to ride a profit with huge leverage.

Obviously, the plan worked.  They made over $1.5 billion on that trade.

Now, what many people don’t know is the size of that leverage on the trade.  Druckenmiller suggested to Soros that that they put 100% of the fund in the trade.  Soros disagreed.  He said they should have 200% in the trade.

Having 200% means leverage of 2-to-1.  That’s not 10-to-1 or 20-to-1 like a lot of novice commodity traders use and it’s certainly not 50-to-1 or 100-to-1 like the snake oil FX brokers tell the public they can use, either.

Druckenmiller said in one interview that the leverage at Quantum (Soros’s hedge fund) rarely exceeds 3-to-1 or 4-to-1.  So if one of the best traders in history doesn’t go beyond 4-to-1 leverage, why the heck would a lesser trader think that going 10-to-1 or more is a good idea?

Do keep in mind that just because they leveraged 2-to-1 does not mean that they were risking the entire amount.  Soros is known for taking a quick loss without regret if the market proves him wrong.

Market Wizard Wisdom

Larry Hite is one of the Market Wizards interviewed Jack Schwager’s famous book.  On the subject of leverage, he said that, “…if you leverage more than 3-to-1 that you are a loser. Because we found that if you did 3 to 1 you would have, even with perfect knowledge, you could go down a third.”

So here we’ve got yet another successful trader with several decades of performance to back his reputation, and he’s telling traders that the maximum leverage that they should consider is 3-to-1.

There are only two reasons I can think of that a person would use higher leverage than what the pros use: ignorance or greed.  And once you are made aware of the risk of using high leverage, you can no longer claim ignorance for your excuse.

Protect Yourself

Brokerage firms want you to use the available leverage.  The more you trade, the more commissions they make.  Don’t think for a minute that they’re going to step in and tell you that you’re taking too much risk.

Sure, the brokerage firms will issue margin calls.  But that’s not about protecting you; it’s about protecting them.  Brokerage firms don’t mind if you are burning through your trading capital.  “Churn and burn, baby.”  It’s just when the flames get too close by putting them at risk of a potential deficit that they’ll step in and tell you to wire more money to your trading account or liquidate your positions.

Surely, the good ol’ US government is protecting you, right?  Well, consider this: The SEC just approved the launch of a 4x leverage ETF.

I wrote in a prior post about how leveraged ETFs are constructed as an easy way to the poorhouse.  You can be right on the underlying market and still lose money.  That’s the effect that double and especially triple leverage ETFs can have.

But now the government is going to allow us to trade in quadruple leverage ETFs?!  Maybe it would be more accurate to re-label these genius derivatives as WTFs

The point is that nobody is going to be as careful about protecting your capital as you are.  To be successful, a trader and investor must be proactive and accept personal responsibility.  Part of this includes understanding and setting limits on leverage.

It Can Get Worse

Do you have a trading system that you’ve back-tested over decades of data?  Have you tested it on out of sample data as well?  Have you run a Monte Carlo simulation on it, too?  That’s good.  You’ve done your homework.

I’m sure you also remembered to factor in commissions and slippage in order to get a better feel for real world trading.  You now know what sort of worst case drawdown would’ve occurred, which can help you determine your comfort level for the amount of leverage you’ll use to trade it.  Time to get trading.

Not so fast!

The well-respected trader Peter Brandt said, “A trader’s worst drawdown is the one yet occur.”

Consider that fact that the worst drawdown in your back-testing record or even your real-time track record got that title by being even worse than all the prior drawdowns that preceded it.  That means it’s possible that another drawdown can come along and steal that title at some point.

All records were made by breaking another record.   That can be both a good thing and a bad thing.  On the subject of drawdowns, it’s definitely a bad thing.

Storm Prep

One simple way that a trader can build a protective buffer is to prepare for a drawdown that’s double the size of the biggest one to date.  This means adjusting your risk-per-trade to a level that will allow you to endure such a losing streak.

Furthermore, you may want to calculate what your entire portfolio risk is.  This means looking at the effect of a worst-case-scenario where every position in every sector of your account gets stopped out with slippage.  This drawdown is your Portfolio Meltdown Level.  It rarely, if ever, will happen.  But you still need to be prepared for the possibility of it occurring.

Does that Portfolio Meltdown Level make you sick?  Well, it’s a good thing that you’re calculating it then!  You just discovered that you’ve been taking too much risk…and you’re lucky enough to have not found out from experience.  Dial the Portfolio Meltdown Level back down to your comfort level.  Figure out what you want to set for your maximum risk level for each trade, for each sector, and for your entire portfolio.

Preparing a worst-case scenario defense plan also means reigning in the amount of leverage used.  Just because you have protective stops in for your positions, doesn’t mean your maximum expected risk level is guaranteed.  If some of the rock stars of the trading world think the maximum leverage they should use is 3-to-1 or 4-to-1, then perhaps you should consider adopting these levels as your maximum leverage limits as well.

We don’t know when the storm will hit, but we do know that it’s inevitable that it will happen someday.  Your job as a trader is to make sure that you are taking the necessary precautions to survive it.  Remember that your probabilities of trading survival are inversely correlated to the levels of leverage that you use.

More Articles by Jason Pearce:

US Dollar: The New Bear Market?

Equities: US Against the World

Profiting From Failure: The Wash & Rinse Trade, Part II

Profiting From Failure: The Wash & Rinse Trade, Part I

How to Trade with Moving Averages, Part II

How to Trade with Moving Averages, Part I

Market Returns Do Not Equal Investment Returns with Leveraged ETFs

Is The Canadian Housing Market Bad for Canadian Banks?

2017: The Death Year for Stocks

Potential Bond Market Reversal Ahead


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By Jason Pearce

The Greenback In the Red

There is some compelling evidence that suggests that the multi-year bull market in the US dollar has come to an end.  Monetary policy, cyclical and seasonal patterns, and the technical outlook all make a good case of further weakness ahead.

If the US dollar does continue its descent, the first order of business for traders is pretty straightforward: you should be short the US dollar and long some of the other currencies.  That’s a “no-brainer” right there.

Now if you do not fancy yourself as a currency trader per se, don’t dismiss this conversation just yet.  You’re other investments may still be greatly affected by the trend in the US dollar.  Even if you’ve stuffed all of your cash under a mattress or converted everything to gold instead of holding one of those pesky fiat currencies, the trend in the value of that dollar still has an impact on your wealth.  It will determine whether you are gaining or losing purchasing power.  Being unaware of the trend in the greenback is irresponsible and staying unaware is downright foolish.

You should also pay particularly close attention to the trend in the greenback if you trade/invest in commodities and raw materials.  The effect of the US dollar’s trend is probably most noticeable here.  A rising US dollar means that US goods are more expensive to the rest of the world, so demand softens.  Price follows.  Conversely, a declining US dollar means that US goods are becoming cheaper to the rest of the world, so demand and price will rise.  This isn’t always the rule, but it stands true the majority of the time.

Interest Rate Effect

Interest rates are a major driving fundamental factor for currency trends.  In broad strokes, currencies trends are expected to move in tandem with interest rate trends.  If rates are rising, the currency should rise.  Conversely, if rates are declining, the currency should head lower.  This is Economics 101.

On the surface, the correlation between rates and currencies makes sense.  After all, investors are yield chasers.  They want to own the currencies with the highest yield in order to get the biggest bang for their buck…or Euro…or yen, etc.

In real life, however, it’s not always quite that simple.  Currencies often have a tendency to lead the target by factoring in the trend in monetary policy.  It’s a good example of that old Wall Street saying, “Buy the rumor, sell the fact.”  This does not happen every single time, but it does seem to happen quite often.  Often enough to wonder why you ever bothered to take Economics 101.

The current trend for US interest rates is higher.  On December 14th, the Fed raised rates for the first time in a year.  They hiked again in mid-March and are expected to do so yet again in June.  As a matter of fact, there are many economists and Fed members who see a couple more hikes before the year is out.

During this current trend in monetary tightening, it appears that the news of higher rates is discounted.  The US dollar index peaked on January 3rd a penny and a half higher than what the day’s high was when the Fed first hiked rates in mid-December.

When the Fed hiked again on March 15th, the greenback actually dropped about a penny and a half.  It has made a series of lower lows and lower highs since then.

If this current behavior pattern persists, the dollar could experience even more weakness at the mid-June FOMC meeting.  This would simply confirm that the tightening cycle has been completely priced in.

Presidential Cycle

The US Presidential cycle shows that the US dollar index often surges after the election, despite who wins.  This rally finally runs out of gas just before the middle of the year after the election.

This year, it appears that the expected peak in the greenback came early.  On January 3rd the dollar crested at a multi-year high and has been working its way lower ever since.

The second half of the post-election year starts in just a few weeks.  This is where currency traders should be paying close attention.

According to the US Presidential cycle, the second half of the post-election year is an ominous time for the dollar as the roadmap points lower for the next two years.  Bounces are expected along the way, but if this cycle holds sway, they won’t last long.  Rallies should be viewed as temporary events and short sale opportunities.

Seasonal Pattern

Based on the greenback’s seasonal pattern, we’re just a month out from where a major decline could commence.  This dovetails perfectly with the projection of the US Presidential cycle.  If so, the next few weeks could present an ideal timeframe to watch for a short sale opportunity.

Before we talk about this seasonal outlook, though, it is important to keep in mind that the seasonal patterns and cyclical patterns do not tell the US dollar what it has to do in the future.  These patterns are a statistical measurement that tells us what the market has done in the past and provides a projection of the most probable outcome moving forward.  Still, it creates a well-worn path that, if used properly, a trader can use to get an edge.

When I say used properly, I mean combining it with price action and giving the current price action priority over the seasonal and cyclical patterns.  If the buck follows the same path in 2017, trade accordingly.  But if the buck deviates from the path, do not try to force it into complying with your wishes.  The market will quickly show you who the real master is.

Now, onto the seasonal pattern…

The US dollar index has a seasonal tendency to peak in the first half of March and then decline until early May.  The buck stuck to the script for this part of the year as the March high was posted on March 2nd and the dollar headed lower for the next two months.

From early May though the start of July the greenback has a seasonal tendency to rally sharply.  So far, that has not been the case in 2017.  The buck has bucked the pattern as it moved lower throughout the month of May and recently touched the lowest price since the Presidential election took place.  This right here is a prime example of why traders need to obey price over seasonal patterns.

The first week of July is supposed to mark an important seasonal top that is followed by an overall decline until late October.  Around Independence Day, we should expect fireworks in both the literal and the figurative sense.  Currency traders should monitor the US dollar index closely once the second half of 2017 is underway.

A perfect setup from here would be for the greenback to make a bear market rally in June and then roll over after the first week of July.  If the buck bounces over the next few weeks, watch to see if there’s a moving average or chart pattern that supports the rally.  Also, observe how it reacts to technical resistance on the way up.  If the rally starts to erode once July starts, it could be a good clue that the next downdraft in the dollar has begun.

What Say the Charts?

On the daily timeframe, a Death Cross occurred on May 26th when the 50-day Moving Average closed below the 200-day Moving Average.  This is a well-known sell signal.  The last time it occurred was fourteen months ago and the greenback dropped for several more weeks afterwards.

More important than this Moving Average crossover signal, though, is the obvious bearish price pattern unfolding right now.  The US dollar index posted a multi-year high of 103.82 on January 3rd and then dropped to a low of 99.23 on February 2nd.  A bounce to a lower high of 102.26 on March 2nd was followed by a decline to a lower low of 98.85 on March 27th.

Once the Groundhog’s Day low was broken, the greenback had officially established a lower low and a lower high.  This downward trend has been confirmed as additional lower bounce highs and lower corrective lows have followed.  Until this pattern is broken, consider the US dollar to be in a well-defined downtrend on the daily chart.

On the weekly timeframe, the US dollar cracked important trend line support at the end of April.  The trend line was drawn across the May 3, 2016 low of 91.91, which set the low for the year, and the June 23, 2016 correction low of 93.01 that was established in reaction to the Brexit vote.

The US dollar index tested this trend line in August and September and then recovered.  The trend line really proved its worth during the Presidential election when it made a knee-jerk reaction and collapsed to a one month low, tagged the uptrend line, and then exploded higher just hours later.  The trend line confirmed its credibility.

After undercutting the Groundhog’s Day low on March 27th and touching the weekly trend line again, the buck bounced.  This was not a surprise.

The surprise came a month later when the bounce faded and the greenback opened ‘gap down’ on April 24th.  The US dollar had all week to recover the trend line, but it never did.  It has been below the trend line since.

Interestingly, the brief bounce into the May 11th high took the greenback right up to the bottom of the trend line and it immediately shrank back from it.  This confirms a classic charting rule: Technical support, once it has been broken, becomes technical resistance.

On the monthly timeframe, there are three ways that a case can be made that the multi-year bull market in the US dollar index has suffered a severe blow, maybe even come to an end.

First, there’s the Wash & Rinse sell pattern that took place.  The greenback initially had a double top established between the March 2015 high of 100.39 and the December 2015 high of 100.51.  The buck ran through this top back in November and negated the bearish pattern.  Just a couple of months later, the greenback reversed from making a new multi-year high to closing back under the 2015 top.  This failed breakout has bearish implications.

The second negative on the monthly timeframe occurred at the same time that the Wash & Rinse sell pattern was established.  The Fibonacci .618 retracement of the entire decline from the July 2001 fifteen-year high of 121.02 to the March 2008 multi-decade low of 70.69 was located at 101.79.  This important technical resistance was surpassed in November.  But like a junkyard dog running at full speed without regard to the chain around its neck and the stake firmly in the ground, the buck abruptly stalled out just a couple of pennies higher and was quickly jerked back down.  It appears that the Fibonacci .618 boundary is working.

Finally, the greenback finished the month of May below the 12-month Moving Average of its closing price.  Now, this bearish trend change signal does not always work.  Nothing ever does.  But you can see that a majority of the time it has led to lower prices in the months ahead or at least a multi-month consolidation period.  It rarely pays to bet against this bearish trend change signal.

Different Shades of Grey

The US dollar index is an unequally-weighted basket of six different currencies.  The biggest weighting is toward the Euro currency, which makes up 57.6% of the index’s value.  The rest of the currencies that make up the index are the Japanese yen (13.6%), British pound (11.9%), Canadian dollar (9.1%), Swedish krona (4.2%), and Swiss franc (3.6%).

You can short the US dollar index, of course, but you can also get more specific and bet on the long side of one single currency against the greenback.  There are several to choose from, but I will mention just a few of your choices here.

Since it has the most weighting against the US dollar index, the Euro currency might be a good instrument of choice for dollar bears.  It will run the closest to being a mirror image of the US dollar index.  More importantly, it has significantly more liquidity than the US dollar index does.  In the futures markets, the Euro currently has open interest of just over 451,000 contracts and the US dollar index has open interest of just over 84,000 contracts.  The bullish Euro currency ETF (FXE) has volume of just over 1,150,000 and the bearish US dollar ETF (UDN) has volume of just over 21,000.  Liquidity matters!

Although it only accounts for 13.6% of the US dollar index weighting, the Japanese yen is another currency worth consideration.  It’s a little less correlated to the US dollar index than the Euro currency is, but it’s still highly liquid and traditionally a great currency for trend followers.  In January the yen signaled a bullish trend change via the 20-month Moving Average, which has an admirable track record, and has stayed close to it since.  If you aren’t long the yen yet, there’s still time to hop on board that train.

Earlier in the post, I mentioned that the US dollar’s trend has a strong inverse correlation to commodities.  This also extends to commodity dollars like the Canadian dollar, Australian dollar, and New Zealand dollar.  These are the currencies of commodity-producing countries and are strongly linked to commodity price trends.  Therefore, a decline in the US dollar could be the rising tide that finally lifts these currencies from their multi-year slump.

Choose Your Weapon

All of the currencies can be traded in forex, of course. If you already have a forex broker and a platform you’re happy with, great.  You already know what to do, so just keep on keepin’ on.  But many currencies can also be traded via futures contracts or ETFs as well.  Make sure you think it through before jumping in.

I’m a bit biased because I started my trading career in the futures markets.  That being said, one of the things that I really like about currency futures contracts is that it offers tons of leverage (much more than you really need), but with regulations that they can’t seem to bother with in forex.

I recall a time when I had a stop order filled in forex on a Swedish Krona.  The slippage on the fill was bad enough, but I was really livid when I found out that some of the other banks I talked to didn’t even show that the price went low enough to trigger my stop in the first place!  When I complained to the bank desk I was trading at, they said, “Hey, we’re doing you a favor by even taking an order for a $7 million dollar position in the first place.  You can’t expect to get the same kind of fills as our institutional traders.”  That was the last time that I traded currencies in forex.  At least in the futures market, I know the price range is the same for everybody.

If you’re a smaller trader or new to currency trading, I suggest you steer away from forex and futures contracts for now and look at the ETFs.  You don’t get the same amount of leverage, but hey, you don’t need to mess around with high leverage when you’re new to trading or operating with a small stake.  Your goal should be to focus on following your trading process and preserving capital.

Once you have a few years of trading experience under your belt and your trading capital has grown, then you can proceed to…

Focus on following your trading process and preserving capital!

Perhaps you’ve heard the Zen saying that goes, “Before Enlightenment chop wood, carry water. After enlightenment chop wood, carry water.”

Well, maybe we should have a trader’s saying that goes, “Before Experience follow trade rules, manage risk. After Experience follow trade rules, manage risk.”

You will find that the successful traders don’t use nearly that much leverage, either.  Also, the pros don’t focus on how much money they can make; they focus on how much money they can lose.  Their time and energy is spent on monitoring their trading systems and managing risk, not trying to figure out how to turn a $10k account into $10 million in twelve months of day trading.

It’s a good possibility that the multi-year run higher in the US dollar has finally ended.  It’s time for traders to get loaded for bear.  Make sure you’ve chosen the right weapon (forex, futures, ETFs, options, etc.), you have enough ammo (risk size determines how many shots you can take), and then exercise patience (wait for the right setup and a trade signal).  Remember: A good hunter doesn’t chase; he waits.


More Articles by Jason Pearce:

Equities: US Against the World

Profiting From Failure: The Wash & Rinse Trade, Part II

Profiting From Failure: The Wash & Rinse Trade, Part I

How to Trade with Moving Averages, Part II

How to Trade with Moving Averages, Part I

Market Returns Do Not Equal Investment Returns with Leveraged ETFs

Is The Canadian Housing Market Bad for Canadian Banks?

2017: The Death Year for Stocks

Potential Bond Market Reversal Ahead


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by:  Brynne Kelly    June 7, 2017

Quick Oil Market Stats:

Just a short note regarding this week’s Inventory data.

Inventory Change – Total Build of +9.3

This is an impatient market unwilling to take it’s eye off a bearish narrative and this week’s build in inventory plays right in to that.

Below are a few charts to get a sense of where we are versus this same week in prior years.

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Yearly Comparisons

EIA, Crude Oil, Oil Price Curve, Inventory Comparison

Oil, gasoline and distillate inventories are at similar levels compared to the same inventory week last year, with production quite a bit higher.  By comparison, the entire price curve has shifted $6.00 lower.  How is this year different?

Prior Year June through end of September Inventory Changes

Looking at inventory changes from June – September over the last 3 years, it seems as though the market is bracing for something closer to a 2015 scenario.  This time last year the market was looking forward to some sort of action by OPEC.  Today, the market is eyeing the END of OPEC’s production cuts.

The bearish sentiment this has created is unrelenting and easily fueled by weekly data that once again failed to provide a clear sign that the worst is behind us.  In the last 2 months, total inventories have drawn-down almost 30 million barrels including this week’s build.

We are only a short time into a new era that includes the ability to export oil.  It’s important to remember that the timing of exports from week to week will be volatile. History is still being fashioned.  At this point the market seems unwilling to trust the noise created by the ups and downs of reported exports from one week to the next.

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by Brynne Kelly

[email protected]

June 2, 2017

Is there a case to be made for relative value?

Selling energy at the beginning of April was a great trade.  However, where do we go from here?  Since prices don’t exist in a vacuum, I thought this would be a good time to take a look at how energy inputs have performed relative to energy outputs.

Think of Crude Oil, Natural Gas and Coal as the three major inputs used to produce energy in a consumable form. Their prices are heavily dependent on the demand and price of the products they can be converted into.  The spread (or margin) between the cost of inputs and the sales price of the outputs not only drives investment in these conversion capabilities, but also indicate supply versus demand.

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With all of the focus this past week on OPEC cuts, inventories and demand worries, let’s take a look at the price movements of the three major inputs.


The entire WTI crude oil curve has fallen more than 6.5%  since the beginning of April, 2017.


The front of the natural gas curve has fallen more than 8% since April.

Meanwhile, CSX coal futures have increased over 6% since the beginning of May, 2017.



To get a feel for the relative value of energy inputs, it makes sense to see how consumable energy products have performed.

First off, we have electricity.  Coal and Natural gas are two of the primary inputs used to produce electricity in the US.  While natural gas prices have fallen significantly in the past two months, the “heat rate” has moved higher.  This means that electricity futures prices are not falling as much as natural gas prices.

Another relative value product to look at is ethane.  While it is not normally thought of as an ‘output’ of natural gas liquids, it does take further processing to get it to market which differentiates it from raw production value.

For the past several years, ethane has routinely been ‘rejected’ into the natural gas stream since the outright price of ethane hasn’t been enough to cover processing costs.  From the chart below, you can see that ethane futures have not experienced nearly the drop that natural gas has this year (at least in the front of the curve).


Another obvious consumable output is gasoline.  Gasoline futures have also fallen less than their underlying ‘input’ falling less than 6% compared to oil’s greater than 6.5% decline.

This relative value play can be seen in the rebound of the gasoline crack from its lows in May.  Meaning that while crude oil prices continued to decline, relative gasoline prices increased.

The same is true for ultra-low sulfur diesel (HO).  As oil prices continued to sell-off, distillate cracks actually started to rebound off their May 1 lows.


What does this mean?  Is this a signal?


Oil Spreads

Another place to spot relative value is in oil spreads.

Relative value of oil in one geographic area to another is similar to input/output economics in that differences in prices can impact the movement of production from one market to another.

Key relationships impacting these movements are US prices versus Europe and Asia.  In the past month, US prices (LLS oil in the gulf coast) through the end of the year have gained value with respect to prices in Europe (Brent), yet European prices have lost value relative to Asia (Dubai).  This is not good for US exports.


However, the spread between US and Asian prices has continued to widen.  Meaning that while the economic incentive to move US oil to Europe hasn’t increased, the incentive to move oil to Asia has increased (as seen in the WTI/Oman spread below).


This points to where the market pins their demand hopes.  As long as global oil demand increases, production to meet that demand can come from anywhere as long as the economics support moving oil from one market to another.

Weekly Inventory

This brings us to the weekly inventory changes.

For the week ending May 26, 2017 total stocks declined by (9.9) per the EIA figures below:

The most important part of this week’s inventory draw is seen in the cumulative change in this “summer” totals versus prior years:

The rate of crude oil stock draw-downs this year relative to the last 3 years is certainly impressive, especially considering that oil inventories posted a net build during this same period in 2016 and 2014.

One contributing factor to this draw-down is the growth in US oil exports:


The chart above definitely highlights what could be considered a ‘trend’ of increasing exports and decreasing net imports.  But, it also highlights the fleeting nature of this dynamic from week-to-week.  However, it’s a positive sign to see these export volumes continue to make new highs.

Speaking of inventory levels, we are approaching that time of year when heating oil (distillate) inventories should start to build in preparation for winter heating season (just as natural gas inventory summer builds in preparation for winter).


With all the focus on gasoline inventory and prices, might it be time to take a look at heating oil prices? Spot prices are half what they were at these same inventory levels 5 years ago.

From a relative-value perspective, there is a lot to think about.

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Read More Brynne Kelly Research

Global Oil Spreads Are the Key to Balancing US Oil Inventories

Is a Rotation Out of Oil Into Equities Underway?

Putting Gasoline Inventory Build Into Perspective

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