Forex Hedge Trade Examples
Today we will focus on four examples of how to use Forex options to hedge spot Forex trades. If you need a refresher take a look at last week's article here. Hedging is a strategy used by institutional traders to protect against the adverse and unplanned effects of trades on an asset in a given market. Now that we have let you in on their secret, it is now time to show you a way that the big dogs do it.
Plain Vanilla Options
The plain vanilla option is the easiest way to use a forex option to hedge a spot forex trade. Plain vanilla options are the most simplified type of options, so all beginners should ideally start with this forex option type before progressing to the more complicated types of forex options.
The chart above is a typical picture of what could easily go wrong when a technical analysis play meets a fundamental play. The rising wedge that formed on the GBPUSD is supposed to have led to a bearish reversal, but instead the currency pair spiked higher on a USD negative Non-Farm Payroll report. A trader who shorted the GBPUSD on the technical play would have lost the trade. This could have been prevented with the following Forex option hedge using a Call plain vanilla option as follows:
ISE Options Ticker Symbol: GBP
Spot Rate: 1.5900
Trade: Long GBP Call 1 contract (100 units) September @ 1.5930
Maximum Loss: Premium of 300 pips = $1,000
This is how a typical Forex options trade is set on the International Securities Exchange Holdings Inc (ISE) Options trading platform. The aim of this trade is to hedge against a possible loss on a short trade taken by the trader in expectation that the rising wedge would play out according to plan. This did not happen, so the option was set for execution if the GBPUSD broke out of the rising wedge's upper trend line.
If a trader shorted 1 Standard Lot of GBPUSD in the spot Forex market at 1.5900 with a stop loss of 100 pips and take profit of 200 pips, this trade would have lost $1,000.
The GBP Long Call Forex options trade gives the owner the right to buy £100,000 with $159,300 and have the option of exercising the option within three months. The pre-agreed exchange rate (strike price) is 1.5930 USD for 1 GBP.
The rate on September 19 went up to 1.6230. Having been stopped out for a loss of 100 pips ($1000) in the spot Forex market, the trader decided to exercise the GBP Forex option by buying USD with the GBP100,000 at the new price of 1.6230, getting 162,300 for it. He will therefore make a profit of (1.6230 GBPUSD – 1.5930 GBPUSD) X 100,000 GBP = $3,000 USD in the process. Removing the premium he paid, he will gain $2,000.
His overall gain = Profit from FX Option – Loss from FX Spot = $1,000.
In this way, his spot Forex trade loss has been hedged. If the rising wedge trade in the FX spot market had gone according to plan, he would have made $2,000 from his 200 pip profit target (the Standard Lot which gives $10 per pip), and lost his FX Options premium, giving him a gain of $1,000.
This is an example of how to use a Forex vanilla option to hedge a spot Forex trade.