Editor's Note: The following is an excerpt available exclusively at TheStreet.com from a story originally published by Investment U.
After four years of getting pushed around by the euro, the dollar has been strengthening in 2005. In fact, it's hovering close to the two-year highs made last month. And most likely it is not over.
But how can you invest in or trade that belief? How does the average trader or investor buy and sell dollars? Let's look at the most common and accessible ways to invest in the dollar, and which instruments might be the most useful for your account.
Whether you think the dollar will go up or down, if you want to trade or invest in it, you have to have something to buy or sell. You could always run down to a bank or an international airport and exchange all your euros for dollars, or vice versa. But as anyone who has traveled to a foreign country knows, the transaction fees charged by banks or currency exchange kiosks are huge! So let's look at some more practical alternatives, ranging from the futures and forEx markets to several available mutual funds.
The Futures Market
You can trade the dollar through the
Chicago Mercantile Exchange's
currency futures contracts. Currently, the CME offers contracts in about 16 currencies vs. the dollar, and one generalized dollar index that tracks the dollar compared to a weighted basket of seven other currencies. To trade these contracts, you have to open an account with a futures broker. Here are some pros and cons to futures trading:
: Well regulated, sufficient liquidity, highly leveraged, low transaction costs.
: High leverage brings greater risk, you have to keep up with expiring contracts.
: Leverage makes this an instrument for seasoned and disciplined traders and investors; however, for those who have the experience and skill, this is the way to get the best bang for your trading dollar.
The Foreign Exchange Market
The forEx market is used by institutions and speculators to exchange currencies around the world. In sheer turnover value terms, it is the largest financial market in the world. In this market, all trading instruments are denominated in pairs, such as the euro/U.S. dollar pair, the U.S. dollar/Japanese yen pair, or the euro/Japanese yen pair. Almost all retail forEx trading is done in the spot market, meaning that the instruments are bought and sold for cash and have immediate delivery. To trade or invest in the dollar in the forEx market, you need to open an account with a forEx broker.
: Highly liquid market, can achieve high leverage, very small account equity allowed by some brokers.
: Poorly regulated -- this is not an exchange-traded market and almost all retail forEx trading is done with your broker taking the other side of your trade. Despite the claims of "free commissions," this is a relatively high transaction cost market because the spread and slippage on trades can be very high.
: The lack of regulation makes this a "buyer beware" market. The hidden transaction costs are much higher than meets the eye. These factors combine to make this a less favorable choice for most traders and investors. However, adventurous traders and those willing to take on leverage and fight through bad fills in fast markets can find very active trading here.
Some of the more forward-thinking and leading-edge mutual fund families are now offering individual funds that allow traders and investors to play in the currency markets. All four of these funds correspond to the dollar index that was mentioned in the futures section above. The dollar index tracks the movement of the U.S. dollar vs. a weighted basket of seven foreign currencies.
ProFunds Rising U.S. Dollar fund rises as the dollar index rises and the
ProFunds Falling U.S. Dollar fund rises when the dollar index falls. The Rydex fund family adds a twist by providing one fund that rises twice as fast as the dollar index -- the
Rydex Series FDS Strengthening Dollar fund, and an inverse fund that falls twice as fast as the dollar index rises -- the
Rydex Series FDS Weakening Dollar fund.
: Highly regulated, familiar instrument for almost all traders and investors, widely available, can be used in most retirement accounts including IRAs, classified as "no-load" funds
: Moderate transaction costs: While these are no-load funds, they still have annual costs of 1% to 2% associated with using them; can only buy or sell at the closing value each day; many brokers charge additional fees if funds are not held for a certain period of time (this is not true if you open accounts directly with Rydex or ProFunds -- two fund families that are rare in the mutual fund world, in that they are very friendly to short-term trading and investing, and fund switching).
: This is a well-regulated way for most traders and investors to play the dollar's moves.
With innovative new products like the Rydex and ProFund dollar-based mutual funds, traders and investors can diversify their portfolios and benefit from moves in the dollar.
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D.R. Barton, Jr. is an Investment Advisory Panelist for Investment U. With an MBA and a background in chemical engineering, D.R. has become a top trading and investing systems developer. He's the co-author of Safe Strategies for Financial Freedom, and was co-creator and contributing author of Financial Freedom Through Electronic Day Trading.