Simple solutions

Alexander the Great may not have known all the buzzwords of modern management consulting, but he was a terrific simplifier. Legend has it he “solved” the intractable Gordian knot by cutting it with his sword. Currency traders, including the many spiritual successors of the NASDAQ day-traders of the 90s, can duplicate this solution by replacing a wide array of currency pairs with the simple dollar index (DXY).

In a market that gravitates towards complexity, the reason we should cut the knot is simple: Nearly all traders, whether they choose to admit it or not, really bet on whether the U.S. dollar (USD) is going to rise or fall. Then they search out vehicles with which to express this opinion. As Alexander would have said, if you want to trade the dollar, then trade the dollar. Just as most stock traders really bet on whether the market is going to rise or fall and minimize their asset-selection risk by trading an index such as the S&P 500 or Russell 1000, currency traders should minimize their selection risk by trading the DXY.

The DXY is a basket of six major currencies; euro, Japanese yen, British pound, Canadian dollar, Swedish krona, and Swiss franc. Each currency is liquid and has a reliable structured interest rate market; collectively they create an index that represents the directional flow of the USD globally with tight, efficient, low-cost bid-ask spreads. Futures and options on the DXY trade at the New York Board of Trade, which in turn is the primary marketplace for price discovery. DXY spreads are 2-3 pips wide, far narrower than what could be achieved by trading each currency individually.

Of course, just as traders can over- or underweight stocks in an index, they can over- or underweight currencies in the six-currency DXY, and the more-active investor can even arbitrage the member currencies against the DXY. In addition, a currency manager with multiple cross-rate exposures can use the DXY futures and options as a hedge.