With the North American stock markets, including the TSX up and around record highs, it is reasonable to be a little worried. Even if you aren’t a flat out bear, it might still be time to hedge your bets. But, how exactly do you do so? It is easy to bet on the market. You just buy a stock after all! But how do you bet, or at least hedge, against the market? For Canadians, the USD is a surprisingly good way to do so.
Betting that a financial position will go down is known as being short. This is in contrast to betting that a financial instrument will increase in price, known as being long. One way that you can be short is by actually doing something called “shorting” the stock. This is a process whereby you borrow a stock and plan to buy it back at a lower price in the future, realizing this difference. Unfortunately, this is a risky proposition as you have potentially limitless liability, coupled with a limited potential profit. Because of this, many brokers will limit the ability of their clients to short stocks.
Negatively Correlated Instruments
Though certainly there is money to be made shorting, it is not for the fainthearted. Another way you can be short the market is by buying instruments which are negatively correlated with the market. By moving some of your money out of the stock market and into these negatively correlated instruments, you can realize a profit if the market moves lower.
One of these modestly negatively correlated instruments is the USD when compared to the Canadian dollar.
USD Exposure
As you can see, the US dollar (USD/CAD) is somewhat negatively correlated with the North American stock markets, including the TSX. Admittedly, I got this idea from Guggenheim Investments and their wonderful investment correlation matrix. I highly recommend you check it out for more correlations.
You should note that the relationship between the US dollar and the overall stock market is not set in stone. Occasionally, they will both move in the same direction. Therefore, being long the USD is somewhere between a short and a hedge against the market in my mind. Various factors evidently play into the price of the USD besides the stock market. That being said, I would say that the risk-return ratio is good in this instance. The USD is the world’s reserve currency after all. It isn’t something which is going to lose it’s value overnight!
Now, if you already hold a significant amount of US dollars and you want to be short the stock market, you can simply hold them. For the rest of us, just know that the banks love to make money on foreign exchange fees and foreign exchange spreads. That means that if you go to the bank to attain USD, you are totally getting ripped off. Fortunately, there are alternative ways that you can gain exposure to a stronger USD compared to the Canadian dollar (CAD).
One of these ways is through a USD ETF created by Horizons called DLR.TO. This ETF tracks the CAD/USD foreign exchange rate. It is available to Canadians and is denominated in Canadian dollars, making it a highly accessible strategy for the average investor with a brokerage account. DLR.TO rises when the USD gains against the Canadian dollar. Conversely, it falls when the CAD gains against the USD. Therefore, by investing in this ETF, you are long the USD.
Because the US dollar is negatively correlated against the stock market, this should be a good bet in the case of a market downturn. In order to verify that this relationship holds, I tested the correlation between DLR.TO and the BMO S&P/TSX Capped Composite Index ETF. The correlation was tested over the ten year period where data was available for both symbols. By doing so, I was able to verify that there is generally a negative correlation of -.46%.
If you are more of a visual learner, this graph shows BMO’s S&P/TSX Index compared to the Horizon’s US Dollar ETF over an ~5 year period.
Norbert’s Gambit
If you are the type of person who likes to hold the greenback in their hands, look no further than Norbert’s Gambit. This slick, tricky maneuver which allows you to get a better foreign exchange rate than the banks will charge you.
Fortunately, the DLR ETF allows you to execute Norbert’s Gambit with ease. By buying DLR.TO (denominated in CAD) and selling DLR (denominated in USD), you are able to get a far better rate than with the banks. This is an option available to many Canadians because of the existence of the Horizons US Dollar ETF.
Confused? Don’t worry, it is a little complicated. It’s also a little bit of work. But, who ever said there was such as thing as a completely free lunch? A fellow stock writer “Dividend Earner” wrote a great article on how to do Norbert’s Gambit which I recommend you check out.
In Short
The USD is your friend if you are looking for a low risk way to hedge against a widespread market decline. You aren’t going to make a fortune if the stock market crashes. But then again, you aren’t going to lose one either! And, at the end of the day, not losing is just another form of winning.
Hopefully you can add this tool to your investing arsenal,
Happy Investing.
