March 04, 2013 at 05:00 AM EST
The Best Way to Trade the Currency Wars
The world may not be engaged in a currency war yet, but it is engaged in a growth war. With domestic demand in most home countries anemic to moderate, the universal objective is growth by exports. Unfortunately, countries doing battle in the growth-by-exports wars end up skirmishing in the foreign exchange markets. That's because every country that wants to export its goods and services wants them to be relatively cheap compared to its global competitors. Driving down your home currency relative to the currencies of the buyers of your products is a way of implementing a "cover all bases" export growth strategy. Of course, as countries trade blows in this "beggar thy neighbor" strategy, besides the danger of a debilitating currency war breaking out, rough and tumble currency manipulation leads to disruptive volatility in stocks, commodities, and bonds. But while you personally can't do anything about currency battles or a full-blown currency war, it doesn't mean you can't profit from all the volatility. Here are some simple ways to hedge your portfolio and have fun trading the markets to profit from bickering neighbors throwing currency Molotov cocktails at each other. To continue reading, please click here…

The world may not be engaged in a currency war yet, but it is engaged in a growth war.

With domestic demand in most home countries anemic to moderate, the universal objective is growth by exports.

Unfortunately, countries doing battle in the growth-by-exports wars end up skirmishing in the foreign exchange markets. That's because every country that wants to export its goods and services wants them to be relatively cheap compared to its global competitors.

Driving down your home currency relative to the currencies of the buyers of your products is a way of implementing a "cover all bases" export growth strategy.

Of course, as countries trade blows in this "beggar thy neighbor" strategy, besides the danger of a debilitating currency war breaking out, rough and tumble currency manipulation leads to disruptive volatility in stocks, commodities, and bonds.

But while you personally can't do anything about currency battles or a full-blown currency war, it doesn't mean you can't profit from all the volatility.

Here are some simple ways to hedge your portfolio and have fun trading the markets to profit from bickering neighbors throwing currency Molotov cocktails at each other.

In a Currency War, All Is Not What It Seems

First, you've got to take a hard look at the stocks you own. If you have big U.S. multinationals that garner a lot of revenues from overseas, watch out.

Companies like McDonalds (NYSE: MCD) or IBM (NYSE: IBM) that generate a lot of their earnings from overseas operations and sales are paid in local currencies wherever they do business. When it comes time to translate their overseas earnings into U.S. dollars, because that's the language we speak here in America, companies have two options.

In this case, you'd better know which option they use.

They can translate foreign earnings on a "constant" basis, which means they take a long-period view of the exchange rate between the dollar the country's currency they are translating into dollars. They might pick last year and say that, based on the average of exchange rate over the last year, which they will use for several quarters, we earned so much in dollars.

Or, they can be more transparent and at the end of each quarter they report earnings based on the current exchange rate -- we earned "this much" (in dollars) from our foreign operations.

When a foreign country's currency is higher and rising versus the dollar, it buys more dollars. That means you can have a situation where a company's sales overseas are flat or negative (which would be a warning sign) but because the money was earned overseas and then translated (for accounting and reporting purposes) into dollars, it looks like their earnings were higher.

But be careful; you'd have been fooled.

The earnings were higher because the currency translation was a positive for the company. Would you want to own that stock if its sales were falling dramatically in the hot markets you thought were their best growth prospects?

What if your big multinational stocks end up with foreign revenues from countries (Japan?) where they are devaluing their currency? Those currencies will buy fewer dollars and earnings. On a translated basis those companies will suffer.

To understand whether your stocks might go up or down, you need to understand how companies translate foreign earnings into dollars and look through earnings to see if sales are good or bad.

How to Trade These Wars for Fun and Profit

If you want to have some fun and make some money on currency moves, there are a few ways to play this situation directly.

Right now the U.S. dollar is the "cleanest dirty shirt in the laundry," so I'd buy it.

As other countries work to knock down their currencies, it's important to point out the U.S. has already done that. Uncle Sam was the first to engage in that policy, but on a very hush, hush "we're not doing that" basis. But QE and keeping interest rates low here is how that's been accomplished, and our exports have been robust as a result.

But now other countries are fighting back and the U.S. is going to the sidelines, on a relative basis.

The way to long the U.S. Dollar is with the PowerShares DB US Dollar Index Bullish (NYSE: UUP) It goes up as the dollar gets stronger. I expect the greenback will continue to be relatively strong, so I would buy UUP.

If you think I'm wrong, you would buy UDN, PowerShares DB US Dollar Index Bearish (NYSE: UDN). It goes up when the dollar goes down.

Either way, the trick is to use technical analysis to trade these currency ETFs.

Chart forPowerShares DB US Dollar Index Bullish (UUP)

If you look at a chart of UUP, you'd want to buy it here at around $22.50, and if you were me, you'd buy more at $22 and some more at $21.50. I'd use a stop of 20 so I wouldn't get too badly hit if the dollar falls.

But to me that's a good, simple way to play what I believe is the tendency for the dollar to be the cleanest dirty sheet in the global currency hamper.

On the other hand, there's the CurencyShares Japanese Yen Trust ETF (NYSE: FXY). The yen has gone down a lot lately because the Japanese government has been pushing it down, and I see it may be bottoming out here.

When I look at the chart of FXY, I want to buy it as it makes a bottom. I'd buy it around 104 and use a stop of 102 to get out if I'm wrong.

Trading currency ETFs is a simple way to play a very grown-up trader's game.

There will be plenty of other currency battle and currency war trades to make in the months ahead. In fact, I believe the hottest trading ahead of us will be currency related trades, and trades based on all the deal-making that's about to explode in the U.S. and across the globe.

That's what I do. I look for smart risk-reward trades to make myself money -- you should try it, too.

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