Shorting the Pound

When searching for new trades, I enjoy returning to past ideas. After all, if a trade done in the past looks attractive again, our research is simplified and the decision making process accelerated. Having done the initial work in the past, we rely upon our body of knowledge to strike again.

An instrument I have spent a great deal of time discussing in my weekly newsletter EPIC Insights has been the British pound. Having traded it many times over the past few months, profits have come from shorting the currency before it fell lower and then covering when it was set to rebound.

Relative strength (RS) is a concept I have been discussing in the Sunday newsletter and weekly commentary for a few weeks.  When an item is overbought, it indicates everyone has rushed to the long side of the trade and that the incremental buyer who is needed to continue driving prices higher is absent. As the pool of buyers dry up, the price declines. An oversold stock is the opposite where people rush to either sell the shares they own or to short the stock. When too many people have rushed to selling, prices rally.

While the contrarian nature of this approach is easy to follow, a strategy that relies on selling what is overbought and buying what is oversold is destined to fail. Oversold stocks can remain oversold for long periods of time. Further, the rally that occurs may be so shallow that those who entered a trade too early are guaranteeing themselves losses.

A perfect example of what happens to those chasing oversold markets can been seen in the British Pound. From an initial short above 163, I amassed a 10% portfolio position with an average cost of 159.57. Using 150 as a target price, the pound became extremely oversold (blue arrow).  On the past three occasions when the currency was oversold (black arrows) a rally occurred. Therefore, we watched for an opportunity to lessen our short position.

On Monday March 1, the pound finally fell below 150 and CNBC trotted out every expert they could find who pointed out that the fall below support was devastating and the pound was set to decline further. I took the opposite view, covered a portion of my short, and wrote a Seeking Alpha article warning that a rally was imminent and those late to this trade would suffer losses. With the rally, the late bears have suffered.

The past few days have proven to be a bounce from the oversold condition. Given the political and economic issues facing the United Kingdom, the currency should fall toward 140 over coming months. With a 5% short position, our portfolio is positioned to benefit from this trend, but I would like the opportunity to increase our exposure.

Once again using the CurrencyShares British Pound Sterling Trust (FXB) as a proxy for the British pound, I recommended increasing the short position in FXB as this week's bonus stock pick.

Related Stocks:  FXB