How to Short Forex with an ETF

This will be the first of a number of posts on how to short emerging market currencies using an ETF.  In this post we will provide an introduction to the topic in the general followed by a “how to” guide for shorting the South African rand specifically.

What Lead Me to This Strategy

As an individual trader it can be difficult to access some of the tools you need to execute more exotic or unusual trading strategies. For example, brokers like Charles Schwab and others have prerequisites in order to trade options so those types of tools aren't available to everyone. Retail clients are quite restricted in the products they have access to, especially when it comes to shorting Forex, which is what I wanted to do. Specifically, I wanted to trade shorts with longer dated contracts against a given currency. Short term products are easier to find but didn't fit my needs. Of course, institutional investors have ready access to these products through the CME, but not smaller individual traders. So, what was I to do?

Upon further research I realized ETFs tied to individual countries could act as a sort of surrogate for the underlying currency of a given country. While these ETFs do not represent the domestic currency directly, I noticed something unusual when I compared the performance of the ETFs with the performance of the underlying domestic currency; namely, that both the ETF and its underlying currency had very strong correlation. After testing my hypothesis against a few country's ETF’s for a period of time, a strategy was born.

Why I Use It

Since the dollar is the world reserve currency, you will find that both emerging market currencies and their corresponding stock markets essentially move in the same direction, either up or down, against the dollar and US stock market. For example, if the rand goes down against the dollar, the value of its stock market (denominated in rand) also declines against US equities (denominated in USD). The strength of this relationship between emerging market currencies and their corresponding ETFs is important because the ETFs can function as a proxy for shorting the underlying emerging market currency while providing smaller retail traders with a tool that is normally reserved for larger institutional investors.

The South African Rand iShares MSCI South Africa ETF

We will use South Africa as an example because the ETF that corresponds to South Africa is the ETF I have utilized the most for various reasons. Subsequent posts will cover some additional emerging markets that I also follow closely as well.

Two charts are provided below. The top chart illustrates the performance of the iShares MSCI South Africa ETF (stock: EZA) over the last year. The bottom chart represents the exchange rate of the rand in dollar terms. Both charts cover the last year of price information but if you go back further the relationship also holds.

In order to further substantiate the relationship between the rand and EZA we will highlight some local advances and declines regarding the rand to dollar exchange rate. We will then observe how EZA performed during these advances and declines. A green value indicates an advance from the previous price and a red value indicates a decline. Please use the charts above for a visual aid as well.

10/29/2019: rand = $0.0683 | EZA = $51.10 (base figures)

1/2/2020: rand = $0.0706 | EZA = $49.48

4/3/2020: rand = $0.0522 | EZA = $26.46

6/10/2020: rand = $0.0602 | EZA = $38.29

6/24/2020: rand = $0.0570 | EZA = $35.33

7/21/2020: rand = $0.0608 | EZA = $39.66

8/7/2020: rand = $0.0563 | EZA = $36.49

9/17/2020: rand = $0.0614 | EZA = $38.93

As you can see, there is direct correlation between the performance of the rand and the EZA ETF. When the rand strengthens, the ETF performs better and vice versa.

Components of the EZA ETF

A list of all the companies, by weight, that are included in the EZA ETF can be found here by clicking on the “portfolio” tab. The largest weighting (23.29%) by far is allocated to a company called Naspers Limited N Ltd (NYSE: NPSNY). Naspers invests in internet companies in a variety of industries such as advertising, fintech, payments, and food delivery.

Which Platform Do I Use to Execute This Strategy?

This strategy can even be accomplished on Robinhood. Robinhood does not charge transaction fees and the platform makes it much easier to access options for the average person. The options contracts on the platform have a variety of expiration dates which are also tailored to my personal trading strategy, which is more buy and hold oriented. In order to trade options, follow these steps (not investment advice):

1. Request and obtain permission to trade options.

2. Search for the ticker symbol of the stock you wish to trade.

3. Click “trade” and then “trade options.”

4. Then select “buy” and “put” followed by the selection of your desired contract expiry.

In order to short the South African Rand, one would search for "EZA" then follow the steps outlined above.

Conclusion

I am personally focusing on a short strategy due to the market forces we are currently in but this strategy could just as easily be used for going long as well. Should one evaluate a given emerging market currency is going to rise against the dollar, a call option could also be placed just the same.