By Evaldo Albuquerque, Editor, Exotic FX Alert
When facing a dangerous situation, you usually take measures to protect yourself.
If you were driving in a bad storm, for example, you would probably slow down to avoid an accident. If you’re walking through a rough neighborhood, you would avoid dark alleys. And if you heard there was a shark sighting, you’re likely to stay on the beach and work on your tan.
These are self-preservation instincts we all have to keep us out of harm’s way.
Unfortunately when it comes to the financial markets, most investors don’t use those instincts. When stocks start to crumble, very few take measures to protect themselves.
Not that I blame them.
Even brokers have difficulty telling you what to do when stocks start to fall. All they know how to do is tell you to “buy stocks at the lower price.” So when stocks start to fall, investors feel like they have nowhere to turn.
So most investors end up doing nothing. They simply watch their stocks tumble and hope they will recover somehow.
You don’t have to settle for that. You can take action during those market downturns. There’s a simple way to hedge against losses in your stock portfolio.
It’s a strategy that involves currencies from emerging markets. As surprising as this may seem, you can use these “exotic” currencies to protect your stock portfolio from major losses. Let me explain how exactly this works…
My Favorite Way to Hedge
Against Stock Losses
When you say the words “emerging markets,” most people immediately think of volatility. This also applies to currencies from emerging markets, or “exotic currencies.” They tend to be more volatile than major currencies. But this is actually a good thing.
Emerging market currencies tend to tumble when stocks are falling. In most occasions, they move much faster than stocks.
By shorting these currencies during bad times, you can easily use some of those trading profits to offset the losses in your stock portfolio.
That’s extremely easy to do in the Forex market. You just have to buy the dollar against those currencies. Let me show you how this works with a recent example.
Stocks had one of the best monthly performances ever this past October. But September was a horrible month, mainly because of the European debt crisis. The S&P 500 index dropped by more than 6% during that period. Some emerging market currencies took it on the chin that month.
European exotics, such as the Hungarian forint, were among the worst performing currencies that month. As you can see in the chart below, the currency fell much more than equities.
The key here is that you can use leverage up to 20:1 with those currencies. So you don’t even have to capture that whole movement to score big gains. You could have made triple-digit gains simply by capturing a third of that move.
Keep This Hedging Strategy in Mind
As you can see, shorting exotics when stocks are falling is a great hedging strategy. It allows you to use some of the short-term gains to offset the losses in your equity portfolio.
In the Forex market, you can use conservative leverage of 20:1, so you can maximize your gains. This allows you to hedge large losses in your stock portfolio with a small movement in the Forex market.
This is a time-proven strategy that’s easy to implement.
In 2008, when the stock market crashed, the dollar rallied against all exotic currencies. In 2010, when the Greek crisis first hit the headlines, the same thing happened. To this date, we see this happening whenever fear takes over the markets.
When stocks go down, the dollar tends to go up against exotics, such as the Mexican peso, the South African rand, and the Polish Zloty.
It’s as simple as that. So make sure next time you think about ways to hedge your stock portfolio, you include shorting exotics in your list of strategies.
Editor, Exotic FX Alert