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Potential Trade: Buy (NYSEARCA: EUO) at $17.57 | Stop-loss: $16.39 | Target : $20.52

Description of EUO

EUO matches twice the inverse of the performance of the U.S. Dollar Price of the Euro. When the Euro goes down 1% relative to the dollar, EUO will rise 2%, and vice versa.

5 Reasons to Buy EUO

1. The risk-reward ratio is high

a. Risk-reward analysis:

The current exchange rate for the EUR/USD is 1.3548. The current price for a share of EUO is $17.57. I believe the worst case scenario for this trade would be the EUR/USD appreciating to 1.40, and the best case scenario would be the EUR/USD depreciating to 1.24. The first scenario would cause EUO to depreciate to roughly $16.39/share. The second scenario would put EUO at roughly $20.52/share.

Risk: $1.18/share (6.7%)

Reward: $2.95/share (16.8%)

Risk/Reward Ratio: 2.5:1

b. Probability of risk being realized:

For the EUR/USD to appreciate to 1.40, I believe several things must occur:

  • The United States Federal Reserve would have to postpone its winding down of its quantitative easing program (highly unlikely based on the economic numbers that have been posted recently in the United States and the recent statements made by the Federal Reserve).
  • The European Union would need to have relatively strong economic numbers (likely based on the recent numbers posted recently in the EU and the forecasts made by many analysts about the economy in Europe for 2014).
  • Central Bankers in the European Union would have to refrain from facilitating a Euro depreciation-I explain this concept later on in the article (moderately likely).

I believe the probability of these three events occurring is 50%.

c. Probability of return being realized:

For the EUR/USD to depreciate to 1.24, some, but not all of the following events must occur:

  • The United States Federal Reserve continues the winding down of its quantitative easing program. (Highly likely)
  • The European Union's economic numbers start missing expectations. (Moderately likely)
  • Central Bankers in the European Union begin facilitating the depreciation of the Euro by making statements expressing the positive economic impact of such an occurrence, creating a quantitative easing program, lowering interest rates, or a combination of the three factors. (Moderately likely)

I believe the probability of some of these events occurring is roughly 50%

2. It is a good hedge against an economic downturn in the EU

a. Probability of an economic downturn in the EU:

In the European Union the unemployment rate has been gradually increasing since the middle of 2007.

In an economic forecast presented on November 5, Olli Rehn, the European Union's Commissioner for Economics and Monetary Affairs, predicted that growth in the European Union is expected to flat line in 2014.

On January 21, 2014, the Center for European Economic Research released its ZEW Survey - which is conducted to make a medium-term forecast about Germany's economic situation-the figure turned out to be 61.7, which was 3.5% lower than the forecast of 64.

The overall sentiment about the overall economic situation in Europe seems to be deteriorating lately.

Graph from Trading Economics

Europe's Gross Domestic Product has been lackluster since the financial crisis of 2008 and is expected to continue to disappoint in 2014.

Europe's inflation rate is at .8% compared to its average of 2.23%

If the Euro Area's strong trend of decreasing inflation continues, we may begin to see a deflationary economy.

b. How holding EUO would hedge against the risk of an economic downturn in Europe:

Many companies in the S&P 500 have a considerable amount of direct exposure to the European economy. Some notable companies with large European exposure are listed below:

  • General Electric (GE)
  • Coca-Cola Company (KO)
  • Phillip Morris (PM)
  • McDonald's (MCD)
  • Abbott Laboratories (ABT)
  • Kraft Foods (KRFT)
  • DuPont (DD)

If the dreary conditions in Europe continue and/or if deflation takes hold in Europe, companies with direct exposure to Europe will be negatively affected.

3. It will give protection against a strong dollar that could affect equity prices in the U.S.

a. Probability of a dollar appreciation that may affect equity prices:

If every country in the world holds its monetary policy constant as the U.S. brings its quantitative easing program to a halt, all other economic factors held constant, the U.S. Dollar will appreciate relative to all other currencies. If quantitative easing continues to gain steam in other countries, fundamentally the U.S. Dollar should appreciate relative to the currencies of countries exercising this monetary policy.

I believe the combination of a strong U.S. economy, the conclusion of the Q.E. program in the U.S., and the continued Q.E. efforts of other countries will cause a dollar appreciation in the next year.

b. Analysis of dollar index

FXstreet

The U.S. Dollar index above measures the performance of the U.S. Dollar against a basket of currencies: EUR, JPY, GBP, CAD, CHF, and SEK.

It is quite apparent that even through the aggressive bond-buying conducted by the Federal Reserve, the U.S. dollar strengthened between July 2011 and today. I believe this means that the strengthening of the U.S. dollar will continue since the Federal Reserve is wrapping up its Q.E. programs.

4. It is the logical next step for EU bankers to facilitate the depreciation of the Euro, which would equal gains for EUO

a. Reasons for facilitating the depreciation of the Euro

The European economy has been lacking over the last few years. They have had troubles with their member countries' inability to repay government debt. To fix this issue, some member countries turned to Austerity which has been a hotly debated issue. Thus far, the attempts to fix the European economy and improve growth among its member countries have failed. It is becoming quite obvious that if nothing is changed, the next problem facing the European Union will be deflation.

This potential deflation could be reminiscent of Japan's deflationary economy between 2009 and 2013. The Bank of Japan fixed the problem of deflation by printing money to increase spending and prices in its economy.

From the graph above, it is easy to see how successful Japan's reflation techniques were on increasing prices.

The graph above shows the JPY/USD prices between 2010 and today. In the area I circled, you can see a tremendous depreciation of the Japanese yen relative to the dollar. This was due to the Bank of Japan's robust quantitative easing program. This program had a wildly positive effect on Japanese stock prices.

(click to enlarge)

www.google.com/finance

The chart above compares the S&P 500 Index to iShares MSCI Japan ETF-corresponds to the performance of Japanese publicly traded securities. Japanese equities were grossly underperforming American equities between 2009 and 2013. The large increase in Japanese equity performance was indirectly due to the Q.E. programs carried out by the BOJ.

The stock market in Japan was not the only area of the Japanese economy that was positively impacted by the actions of the Bank of Japan. Consumer confidence, Consumer Price Index, and Producer Price index have all significantly increased recently.

What does all of this Japanese data mean for Europe? The shot-callers in the European Union will probably pay heed to the success of the recent actions of the Bank of Japan. Japan was experiencing a similar situation to present-day Europe when it decided to reflate its economy. Not only did Japan's money printing stop deflation; it caused a massive stock-market rally, improved consumer sentiment, and improved many areas of its economy.

If Europe makes the decision to start printing money, the Euro will depreciate considerably.

5. It may improve the risk-adjusted returns of your portfolio

a. Correlation coefficient and Sharpe Ratio analysis:

The correlation coefficient of EUO and SPY since the year 2000 is -.5021 which means if your portfolio is largely composed of American equities, adding EUO will surely improve the Sharpe ratio of your portfolio. In other words, adding EUO to your portfolio is likely to improve the risk-adjusted performance of your portfolio.

Conclusion

I recommend purchasing EUO around $17, with a stop-loss set around $16, and a target of $20. Because the risk-reward of the trade is high, it is a great hedge against an economic downturn in Europe, it will give your portfolio protection against an appreciating US dollar, and it will most likely improve the risk-adjusted returns of your portfolio.

Source: Buy EUO To Hedge Your Portfolio