Again and again, we are asked in our community, via email or in our webinars, how we manage the currency risk in our trading account, which is reason enough to present our thoughts and suggestions in this article.
What is the currency risk in the trading account?
The currency risk in a trading account exists on various levels. First, there is risk in the exchange rate between the selected account currency and the currency in which you have your personal expenses or, if it is a corporate account, in which your company has the most expenses. Second, there is exchange rate risk between the assets and financial instruments in your trading account and the account currency. For example, your account and personal expenses might be in euro, but your portfolio is full of stocks like Apple and Facebook that are American companies and therefore trading in dollar. In this cases you have currency exposure whether you realise it or not.
Choose your account currency correctly
The choice of the right account currency or the choice of currency in the deposit plays a central role in minimising currency risk. We recommend choosing the account currency in the currency in which you have most of your expenses. If you live in the UK and have almost all expenses in pounds, then it makes, in most cases, sense to use pound as your account currency, if permitted by the broker.
If one has, in such manner, selected the “home” currency in the account management section, the currency risk is still not completely excluded, but the main risk factor is restrained.
Watch out: Is your broker just displaying your balance in another currency or completely converting all currency exposure?
There is a big difference between just seeing everything in your chosen account currency and really having your currency converted completely.
If you only display the account balance in a different currency, then you continue to carry the daily exchange rate fluctuations with you. For example, we have deposited 83,300€ into our $100K real money account to start the account with $100,000, taking into account the current exchange rate. So we chose the account currency USD and made our deposit in EUR. As a result of this procedure, we currently have exposure to currency risk, which poses risks as well as opportunities. If the EUR/USD pair rises in price, then our account benefits from it and vice versa.
As it happened, we have incurred a small book profit of $156 right after depositing just because of movements in EUR/USD:
We deliberately did so as we speculated on a slight recovery in the EURUSD, which can bring us an additional profit. Basically, this is just a long trade with a standard lot in EURUSD.
The alternative, without any speculation, would have been to immediately convert the amount paid into USD in full so as not to be affected by current exchange rate changes in EURUSD (outside open trades in non-USD).
Currency risk in open trades
If you carry out a trade in another currency, you carry this currency risk for the duration of the trade, which is very manageable in most cases. It can be concluded that the risk increases with the duration of the trade.
Fortunately, fluctuations in exchange rates are many times lower than in other assets such as stocks, indices, futures or options. For example, a daily fluctuation in equities of 2% is more likely to be considered normal, whereas among the major currencies it is rare for the daily fluctuation to exceed 0.5%. In addition, the change in the exchange rate does not always happen to one’s own disadvantage and thus occasionally generates an additional profit.
How can I hedge the currency risk?
Of course, you can also hedge the currency risk in open positions. As mentioned above, the impact of changes in exchange rates over a relatively short period of time is small and can also be beneficial. But what about when the position is large and the investment is long-term? In such a trade, the risk of currency risk cannot be denied.
A hedge in such a scenario would be relatively easy to do, because you would only have to set the equivalent as a currency position. Let’s look at this through a simple example. Suppose we buy $2,000 worth of Apple stocks, then the risk is that the EURUSD exchange rate will turn against us. Let’s say we have a EUR account and hold this $2,000 Apple position, then we can just go for $2,000 short in USD. If the USD is really going down in value (EURUSD is going up), then the Apple position is going down in value but at the same time we are gaining with our short position in USD, which has the same value.
How much does a hedge cost?
The costs of the hedge are the fees for the additional trade and the resulting overnight costs. The longer the trade is held, the higher these costs will be due to ongoing costs. These costs are negligible in most cases and can pay off, but the other options we are mentioning in this article can be even easier in many cases.
Should one keep the account in USD if one trades only US stocks?
As we mentioned earlier, we do not see any sense in keeping your account currency in US-dollars just because you are trading US stocks. Of course, if you do so you completely exclude the currency risk, but this only applies until the moment in time you want to withdraw the money (from the perspective of a euro or pound country resident). Nonetheless, this remains an option for those who expect the USD to appreciate against the local currency.
Example: Let’s say you deposit 10,000€ into a trading account and keep the account in USD. At the time of deposit, the exchange rate stands at 1.2000, which results in starting with a $12,000 account. Over the years, the account develops magnificently and grows to $20,000 and the account holder decides to close the account. The profit is $8,000, which is 6,667€ at the original exchange rate. But in the meantime, the exchange rate has dropped to 1.1000. Considering the current exchange rate of 1.1000, then the profit is even 7.273€. So there was an additional profit of 606€.
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Update from June 15, 2018: We recently moved all of the cash in our $100k account into USD since we believed in dollar strength and euro weakness which has paid off due to the ECB announcement.