How to Hedge a Forex Trade
People who own gardens constantly have to keep them trimmed. They do this to keep them neat and prevent them from growing out of control. The same concept is also used in Forex trading. It's called Hedging. In Forex, hedging refers to the methods and strategies used to protect a trading account from excessive risk. Hedging can also be defined as a strategy that uses compensatory price movements to enable the trader to cover the risk on another trade.
Hedging in Forex – Have a Plan B
The reason why we are talking about hedging today is because institutional traders use it liberally to offset losses they have incurred on other trades. This is part of the reason why institutional traders like Goldman Sachs rake in billions of dollars from the markets, funded in part by the un-hedged losses made by retail traders. Is it ok to keep losing money this way when some modifications to your trading strategy to include hedging techniques can make all the difference? If your answer to this question is no, then this is your chance to take your game up a gear or two.
Hedging in Forex Trades
The spot Forex market is not the only way to trade currencies. Currencies are also traded in the futures and the options market. It is therefore possible to use currency options to hedge against any positions taken on the same currency pair in the spot market.
How does this work? To fully understand the workings of the currency options hedge, we will explain how currency options work.
A currency options contract gives the trader the right (but does not obligate the trader) to enter into a contract on a currency pair at a specified exchange rate for a certain period of time. Such a right is granted by the option seller (broker or dealer) in exchange for an upfront payment from the trader known as the premium.
What does this mean? It means:
a) The trader can purchase an options contract from a broker at a certain price (the exchange rate). He may purchase a contract with a bullish expectation (call) or a bearish expectation for the currency pair (put). A contract contains 100 units of the asset.
b) The contract lasts for a maximum of three months. It can be anything between one day to three months, but never exceeding three months.
c) At the end of the contract period, the trader can do two things. He can either sell the contract he purchased (i.e. exercise the contract) back to the broker at the existing market price (not compulsory) OR he can allow the contract to expire in his hands, and depending on the new price and the direction of the contract purchase, the contract can expire in profits or expire worthless.
Now how can the currency option be used as a hedging technique in Forex?
If the trader is long on a currency pair in the spot Forex market, he is expecting the currency pair to move higher and therefore gain from the appreciation. However the trade may not end this way. In order to hedge this trade with a currency option, the trader has to purchase a PUT option contract with the possibility of gaining from a possible bearish movement [in the opposite direction] – if it does happen. Conversely, the trader can purchase a CALL currency option to hedge against a short position in the spot Forex market.
The way the trades are structured is as follows:
Scenario 1
– Long trade in spot Forex market.
– Put option in Forex options market. Trader pays a premium to the broker.
If spot trade ends higher, spot trade wins. The trader allows the Put option to expire worthless, and loses only the premium. Gain from spot trade MINUS premium on option trade will give a profit.
Scenario 2
– Short trade in spot Forex market.
– Call option in Forex options market. Trader pays a premium to the broker.
If spot trade ends higher, spot trade loses. The trader must then exercise the Call option by selling to the broker. He will gain from this since price of option is now higher than what he bought it initially. Gain from options trade (gain from trade – premium) MINUS investment on spot trade will give a profit.
In the next article, we will give 4 trade examples using simplified Call/Put forex option hedge trades to illustrate the hedge strategy.
