I had heard of the "power of the blogosphere," but hadn't experienced it first hand until now. In a post two days ago, I explained why the yuan was a "sure thing" to appreciate against the dollar for years to come, and introduced readers to the most conservative method to take advantage of that appreciation. Imagine how surprised I was yesterday to see that the yuan had just made its biggest ever advance against the dollar since China first abandoned its "dollar peg" in 2005.
For more details, you can read the entire story here: http://www.bloomberg.com/apps/news?pid=20601087&sid=aJRdZS_2FxtM&refer=worldwide.
I can only assume that my many readers rushed to buy the yuan yesterday after reading my post, causing this big rise in the yuan's value. Just kidding!
Two days ago we discussed the most conservative method to play the ongoing rise of the yuan - how to deposit money into a yuan account. Today we will discuss a more risky, but potentially much more profitable, method - buying yuan futures contracts. The above picture shows the trading pits of the Chicago Mercantile Exchange, the rough and tumble arena where the only yuan futures contracts in the world trade.
Futures contracts are exactly what they sound like - a contract to deliver a certain quantity of a specific commodity (in this case, Chinese yuan) at a set price at a specified contract expiration date in the future. You can go "long" or "short" a futures contract, depending on whether you think the yuan-dollar rate will go up or down in the period of time between when you buy a contract and when it expires or is sold to another investor, whichever comes first.
For example, if you had a futures brokerage account, you could go online or call your broker today and buy a futures contract that entitles you to receive 1,000,000 Chinese yuan on March 18, 2008. At the time of this writing, the market price for that contract is quoted at $137,860, which works out to an approximate exchange rate of 7.25 yuan per dollar. The actual exchange rate in the cash market (what you would get if you went to a bank in China and exchanged cash money) is 7.47 yuan per dollar today, so futures traders are currently betting that the yuan will rise in value by approximately 3% against the dollar between October 2007 and March 2008.
So far so good. Now comes the best part. A key difference between stocks and futures contracts is that you pay for the value of a stock in cash at the time you buy it and don't get paid back until you sell that stock at some point in the future. This would not be practical for futures contracts because most investors and speculators would not want to tie up $137,860 of their hard earned money on just one investment for five months. So futures markets like the Chicago Mercantile Exchange do not require investors to pay for a futures contract at the time they buy it. Instead they are only required to put down a good faith deposit called a margin payment at the time they buy the contract.
For the Chinese yuan contract, the required initial margin is $1,350 and the maintenance margin is $1,000. This means that a speculator must have $1,350 of uncommitted cash or interest-bearing Treasury bills in their account to control one yuan futures contract, and once they have purchased the contract, they have to maintain at least $1,000 in cash or interest-bearing Treasury bills in their account at all times until they sell the contract to someone else.
Think about that for a minute - in the futures market, you can control 1,000,000 Chinese yuan for the life of a contract by merely posting a $1,350 deposit, and if your deposit is in the form of Treasury bills, you're earning interest on your deposit while you wait for the contract to move in your favor! If you bought a contract at today's price of $137,860, and then held it for six months during which the yuan rose against the dollar by just 3%, you could sell it for $141,996. That's an increase in value of $4,136, which when compared to your initial deposit of $1,350 equates to a gain of 306% in six months on an investment that only actually went up by 3% in value!
So what's the catch - why isn't everyone doing this and becoming rich? There are two reasons, one applicable to all futures contracts, and another that is specific to the yuan contract. The first reason is that "leverage is a double-edged sword." If the dollar was to rise against the yuan by more than the $1,000 in maintenance margin in your account, you would receive a "margin call," and have to either liquidate the position at a loss or put enough extra money into your account to maintain the required $1,000 dollar maintenance margin. It's actually possible to lose more than your original investment this way. This not so friendly downside of futures trading is the origin of those stories about everyone's apocryphal uncle who "lost his shirt in soybeans."
The second reason is that the yuan contract has very low trading volumes, which makes it hard to get a buy or sell order filled at a price close to the actual market price. Bad fill prices on both ends of a transaction can greatly reduce the size of your profit on a given trade. The low volumes are due to the fact that the yuan contract is still very new and unfamiliar to long-time pit traders, and because the yuan's appreciation is still slow - steady but slow. Futures traders want contracts that make larger and quicker moves so they can take advantage of the huge leverage inherent to futures trading to make outsize profits.
Once the Chinese government makes the yuan fully convertible, however, all that will change. As the yuan starts making bigger and bigger leaps forward against the dollar, currency futures traders will come streaming into the market and create much larger daily trading volumes, which will enable traders to get better fill prices on their trades. Right now, as traders wait for those greater volume days to arrive, many speculators trade the Japanese yen instead as a far-from-perfect substitute for the yuan, due to the tremendous liquidity of the yen futures contracts. We will discuss investment opportunities in the yen in future posts.
The bottom line is that while most investors prefer to stay away from futures trading due to their concern about the high leverage involved and the potential to lose more than their initial investment, the yuan futures contract provides an almost unique opportunity to exploit the high leverage of futures with a much greater margin of safety due to the extreme rarity of the ultimate rise of its underlying commodity being a near certainty. I would open a futures account if I didn't already have one, and use this "calm before the storm" period to dip your toes into the water and get comfortable with the mechanics of futures trading so that you will be ready to hit the decks running when the yuan becomes fully convertible.
(I have found XpressTrade to be a great choice for a commodities brokerage for those interested in saving money on commissions by doing all their trading online. They have great customer service and very low commissions. They can be found at this link:
http://www.xpresstrade.com/why_trade_here.php.)
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