The historic rise in the U.S. dollar has been a major overhang on the market for nearly a year.
According to FactSet Research, the U.S. dollar has appreciated by 19% against the euro and 16% against the Japanese yen in the past 12 months.
This has regularly been cited as the reason for companies’ missed sales and earnings. For example, during its July 9 earnings release, PepsiCo (NYSE: PEP) warned that dollar strength could cause a negative impact of 11 percentage points on its full-year earnings.
The stronger dollar has also hurt commodities. The price of gold is down 15% over the past 12 months and oil is down almost 50%.
While the dollar’s uptrend has paused since its March peak, there is good reason to believe a catalyst may soon send it shooting higher.
Fortunately, there is still time to protect your portfolio from the fallout — and one option strategy may even offer the opportunity to profit.
Is the Market in Denial?
Two factors are driving the dollar’s historic rise: fear of an interest rate increase by the Federal Reserve and strength in the U.S. economy relative to the rest of the world.
The U.S. central bank has been able to play the waiting game on a rate hike, but it increasingly seems like Fed Chair Janet Yellen is trying to prepare the market. In May, she said: “If the economy continues to improve as I expect, I think it will be appropriate at some point this year to take the initial step to raise the federal funds rate.”
The most recent statement by the Fed on July 29 reinforced this, noting that the economic recovery was driving “solid job gains and declining unemployment.”
The Fed has already had to backtrack on its plan to use 6% unemployment, which was achieved in October, as a signal to raise rates. Weekly unemployment insurance claims, reported at 255,000 on July 29, are the lowest in 41 years. Additionally, the four-week average number of claims is approaching a point that has signaled full-recovery in previous economic cycles.
With the economy approaching what could be full employment, wage growth and faster inflation may not be too far off. Other economic headwinds Yellen noted in her May speech, including slowing global growth and tight credit standards, are starting to diminish as well.
It all makes for a difficult argument against a rate increase. The market has breathed a sigh of relief after each FOMC meeting, but there are only three left this year. The Sept. 17 meeting will include a press conference, economic projections… and quite possibly a surprise rate increase.
A rate increase could send stocks, especially interest rate-sensitive ones, plunging. It may not be the impetus for a prolonged bear market, but we should still be prepared. Luckily, one option strategy can help us protect our positions and potentially profit from the move.
With or without a rate hike in September, there is little downside risk to the greenback. The World Bank is forecasting economic growth of 2.7% in the United States for 2015, more than double the 1.1% rate for Japan and well above the 1.5% rate for the eurozone. Other major central banks, most notably the Bank of Japan and European Central Bank, are still in the middle of their quantitative easing programs, which could drive inflation and currency debasement.
I still think the economy has room to grow and do not want to sell out of my positions — but I also think the risk of a hiccup from a September rate surprise is too great not to be prepared. Therefore, I plan to sell put options on PowerShares US Dollar Bullish ETF (NYSE: UUP).
If you’re not familiar with this strategy, don’t stop reading here. Many people think options are too risky, but when used properly, put selling is a conservative, high-income strategy.
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With shares of UUP trading for $25.50 at the time of this writing, we can sell the UUP Sep 27 Puts for about $1.55 per share ($1,550 per contract).
If UUP closes below the $27 strike price at expiration on Sept. 18, we will be assigned 100 shares per contact at that price. Since we received $1.55 in options premium, our actual cost is $25.45 per share — a slight discount to the current price.
To be prepared for this scenario, we want to make sure we have enough money in our account to cover the purchase. This means setting aside $2,545 for every put contract we sell plus the $155 we collected.
This option expires one day after the Fed’s September meeting. A rate hike or even an upgrade in economic projections will likely cause the dollar to jump, which could have a negative impact on some of my positions in commodities and rate-sensitive stocks. However, a jump in the dollar would be good for my put selling strategy.
If UUP closes above $27 on expiration, the option expires worthless and we keep the $155 premium, earning 6.1% on the $2,545 we set aside in 50 days, or 44% annualized. That extra income will help offset short-term weakness in other parts of our portfolios.
Note: Using another options strategy, millionaire trader Jared Levy generated a 141% annualized return in UUP risking only $165. Since launching his Profit Amplifier service in March, his track record has been amazing, with annualized gains as high as 2,201%. To learn about his simple strategy or get his next trade, follow this link.