Bucking the Dollar
The UUP ETF options are gaining interest.
Stepping UUP to the Plate
Share and option volume in UUP have been steadily rising since October, with the underlying now trading an average of 5.8 million shares a day and the options around 50,000 contracts a day. Those numbers are up about 65% from the third quarter in 2008 and place it as one of the more active and liquid ETFs. For comparison's sake, the Oil Services HOLDRs (OIH) averages 7.2 million shares a day and 31,000 option contracts a day, and the iShares Bond (TLT) trades around 1.9 million shares and just 18,000 option contracts a day. Also, the open interest in the UUP -- which currently has over 5 million contracts open -- stacks up well to other popular ETFs such as Spyder Gold (GLD)
Aside from the increased liquidity which brings tighter bid/ask spreads, another attraction of the UUP is that it does a pretty good job of tracking its benchmark US Dollar Index (DX). Since the dollar bottomed around $74.50 in the beginning of December, the Index has climbed some 4% to $77.45; likewise the UUP has gained similarly since its December 1 low.
It should be noted the UUP isn't without quirks, which was highlighted in early November when it was announced that it would temporarily suspend issuing new shares. This caused a two-day dislocation in the ETF's price relative to the Dollar Index.
As the dollar fell the past few months, open interest in the call options rose steadily as investors used the leverage and limited risk nature of options to try to catch a bottom.
With the chart of the Dollar Index and UUP now poised to break a 10-month-long downtrend, the options make an attractive way to play reversal in the dollar.
The UUP and its options has, in fact, become one of the favorite vehicles for institutions and hedge funds to make large macro bets or offset currency risk in their portfolios. This is evidenced by the numerous option transactions that have come in large blocks of multi-thousands of contracts. There have been four different occasions in the past three months in which the UUP recorded one of the top-five option transactions of the day.
For example, Tuesday the UUP is on pace to trade over 200,000 contracts, with the largest trades being the purchase of 100,000 of the $24 calls that expire in January 2011. Given that prior open interest in the strike was zero, this is likely a large fund making a new long-term bet on a rebound in the dollar or hedging its currency exposure.
Aside from a speculative position or making a directional bet on the dollar, the UUP and its options can be used as a means to hedge your stock portfolio from currency risk. Much of the recent rise in stock prices has been attributed to weakness in the dollar. It's been especially beneficial to large-cap multinationals, such a Procter & Gamble (PG) that generate more than half their revenue overseas, or commodity-based companies such energy or metals which are priced in dollars.
As large caps and commodities have recently outperformed small-cap or higher-beta names, individuals might be finding their portfolios are overweighted in these sectors. One way to hedge against the possibility that renewed strength in the dollar would undermine exports or asset values would be to buy calls on the UUP.
While this would by no means be a perfect hedge, just as buying VIX calls doesn't necessarily insure against a market decline, it would provide some measure of protection should a rally in the dollar cause a rotation out of large caps and commodities.
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