Hedging in foreign exchange can be used to protect one’s position in a currency pair against a negative move. This is a short-term hedge used by traders when they believe that news or an event may trigger volatility in the FX trade. When contemplating currency pairing hedging in this fashion, two related notions emerge: Hedging currency positions by simultaneously shorting and longing the same currency pair is a common strategy, as is investing in forex options.
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The First Strategy
A forex trader can “hedge” their portfolio against the risk of a negative shift in the value of the underlying asset by placing long and short positions in the same currency pair. A “perfect hedge” is the best type of hedging since it removes all risk (and consequently all potential profit) from the trade while it is active.
Selling a currency pair you are long on may seem illogical because the two positions cancel each other out, but this happens more frequently than you may think. This “hedge” is common when a trader takes a long or short position as a long-term trade and, rather than liquidating it, starts an opposing transaction to establish a short-term hedge in anticipation of big news or an event.
American forex dealers, for whatever reason, restrict this type of hedging. Businesses must instead resolve the conflict by treating the contradictory trade as a “close” order and canceling off the two holdings. However, the eventual result of a “netted out” transaction is the same as that of a hedged trade.
Alternative Plan of Action
A trader can “hedge” an existing position against a negative change in the currency pair by using forex options. An imperfect hedge is one that removes some of the risk while leaving some of the potential gain in a trade.
If you are long a currency pair and wish to reduce your exposure to the risk of a drop, buy put option contracts; if you are short a currency pair, buy call option contracts to protect yourself from the risk of a rise.
Adverse Event Protection is Defective
The buyer of a put option gets the right but not the duty to sell the underlying currency pair to the options seller at the strike price on or before the expiration date in exchange for an upfront payment.
For example, suppose a forex trader is long EUR/USD at 1.2575, anticipating the pair to climb but concerned that it would collapse if upcoming economic data is poor. A trader might limit risk by purchasing a put option with a strike price less than the current exchange rate, say 1.2550, and an expiration date after the economic announcement.
If the news does not cause a decline in the EUR/USD exchange rate, the trader may continue to hold the long EUR/USD position and potentially profit as the exchange rate increases. Remember that the premium for the put option contract was incurred as a result of the short-term hedging.
If the news is made public and the EUR/USD begins to fall, the trader will be reassured to know that the put decreases the danger of the bearish move. When a long put option is purchased, the buyer accepts the risk of the difference between the strike price and the underlying asset’s value at the time of purchase, which in this example is 25 pips (1.2575 – 1.2550 = 0.0025), plus the option premium. Because the put may be exercised at the 1.2550 price, even if EUR/USD falls to 1.2450, the maximum loss is restricted to 25 pips plus the premium.
Upside Risk Protection in Partial
A call option contract grants the buyer the right, but not the obligation, to purchase a certain currency pair on or before the option’s expiration date in exchange for an upfront premium.
Assume a trader is short GBP/USD at 1.4225, anticipating the pair to fall but concerned that it may climb if the upcoming parliamentary vote is favorable. A trader might limit their risk by buying a call option with an expiration date after the vote and a strike price greater than the current exchange rate, say 1.4275.
If the GBP/USD exchange rate does not rise following the vote, the trader can continue to short the pair and profit as it declines. If the GBP/USD exchange rate continues above the strike price and the call option contract expires, the short-term hedging will have cost the same as the option premium.
If the vote is successful and the GBP/USD begins to rise, the trader can relax knowing that the only amount at risk is the premium paid for the options contract plus the difference in value between the pair’s price at the time the options were purchased and the strike price of the option, or 50 pips in this case (1.4275 – 1.4225 = 0.0050).
Given that the call may be executed to acquire the pair at the 1.4275 strike price and then cover the short GBP/USD position regardless of the market price at the moment, even if the GBP/USD climbs to 1.4375, the maximum risk is limited to 50 pips plus the premium.