Forex hedging is a strategy that protects the position of a currency pair against the possibility of a negative move. For example, it is often short-term protection when a trader is concerned about news or an event sparking volatility in currency markets. There are two similar tactics when referring to hedging forex pairs in this manner. A hedge can be set up by taking the opposite position in the same currency pair, and buying forex options is a second method.
Strategy One
By concurrently maintaining a short and a long position on the same currency pair, a forex trader can build a “hedge” to completely protect an existing position from an unfavorable move in the pair. Because it eliminates all risk (and hence all possible profit) connected with the trade while the hedge is operational, this variant of a hedging technique is known as a “perfect hedge.”
KEY LESSONS
- In the foreign exchange market, hedging refers to shielding a position in a currency pair from the possibility of losses.
- In the forex market, there are primarily two hedging methods.
- The first strategy is to take the opposite position in the same currency pair; for example, if investors hold long positions in EUR/USD, they would short the same amount of EUR/USD.
- Using options, such as purchasing puts if the investor holds a long position in a currency, is part of the second method.
- Forex hedging can only provide a small amount of short-term protection when employing options.
- Selling a currency pair you have held for a long time may seem strange because the two opposite positions cancel each other out, but it happens more frequently than you might imagine. This form of “hedge” frequently occurs when a trader has a long or short position in a long-term trade. Then, instead of liquidating it, it opens a contrary transaction to generate the short-term hedge ahead of meaningful news or an important event.
- It’s interesting to note that American forex traders forbid this hedging. As a substitute, businesses must regard the contradictory trade as a “close” order to net out the two holdings. However, the outcome of a “netted out” and a hedged trade is nearly identical.
Strategy Two
Using forex options, a trader can “hedge” a position against an unfavorable change in the currency pair’s value. However, because the resulting position typically only eliminates some of the risk (and hence some of the possible profit) connected with the transaction, the method is known as an “imperfect hedge.”
A trader who is long a currency pair can purchase put option contracts to lessen the risk of a decline in the value of the investment. A short trader of a currency pair can purchase call option contracts to lessen the risk of a rise in the value of the investment.
Imperfect Downside Risk Hedges
- In exchange for an up-front premium, put options contracts grant the buyer the right, but not the responsibility, to sell a currency pair to the options seller at a predetermined price (strike price) on or before a specified date (expiration date).
- Consider a forex trader who is long EUR/USD at 1.2575 and believes the pair will rise. However, the trader is also concerned that the currency pair may fall if imminent economic news is negative. Therefore, the trader could reduce risk by acquiring a put option contract with an expiration date sometime after the economic news and a strike price below the present exchange rate, like 1.2550.
- The trader can hold the long EUR/USD position and earn more money as it rises if the news passes without causing EUR/USD to move lower. Remember that the premium paid for the put option contract was used to offset the cost of the short-term hedge.
- The trader does not need to worry as much about the bearish move if the announcement is delayed and EUR/USD starts to go lower because the put limits some of the risk. The risk once the long put is opened is equal to the difference, in this case, 25 pips (1.2575 – 1.2550 = 0.0025), between the pair’s value at the moment the options contract was purchased and the strike price of the option, plus the premium for the options contract. The put can be exercised at the 1.2550 price regardless of the market price for the pair; thus, even if EUR/USD fell to 1.2450, the maximum loss is 25 pips plus the premium.
Imperfect Upside Risk Hedges
In exchange for an up-front premium, call options allow the buyer the right, but not the duty, to purchase a currency pair at the strike price or before the expiration date.
Consider a forex trader short GBP/USD at 1.4225, expecting the pair to trend lower but also afraid that it could move higher if the impending Parliamentary vote results in a bullish outcome. The trader could reduce some risk by purchasing a call option contract with an expiration date that falls after the scheduled vote and a strike price above the current exchange rate, such as 1.4275.
Forex brokers do not always offer options on forex pairs, and unlike stock and index options contracts, these contracts are not traded on exchanges.
The trader can hold the short GBP/USD position and profit as it declines if the referendum passes without causing the currency pair to go higher. However, if GBP/USD remains above the strike price and the call option contract expires, the short-term hedge incurs costs equivalent to the premium paid for the contract.
The risk is limited by the distance between the value of the pair at the time the options were bought and the option’s strike price, or 50 pips in this case (1.4275 – 1.4225 = 0.0050), plus the premium paid for the options contract, so the trader need not worry if the vote is successful and GBP/USD starts moving higher.
Because the call can be exercised to buy the pair at the 1.4275 strike price and subsequently cover the short GBP/USD position, regardless of what the market price for the pair is at the time, the maximum risk is not more than 50 pips, plus the premium.
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