Hedge fund trader Mark Sellers once remarked that if you “focus on the downside, the upside will take care of itself”. Protecting against adverse currency movements is essential for long term trading profitability. Hedging is a way that FOREX speculators can control their foreign exchange risk.
When used correctly hedging can protect against both long and short currency risk. Here we will look at how hedging foreign currencies works, and why it can help you to control risk in your trading.
What Is Hedging?
Hedging can be used by a trader to protect against a down movement in a currency pair that they have gone long. Hedging also can be used to protect against upward movement in a trade where they have gone short. While there are different ways for speculators to hedge their trades, the most popular are forward contracts and well known foreign currency options.
Hedging Forex Trades Using Currency Options
One of the most popular ways for retail traders to hedge forex is using a currency option. A currency option provides the purchaser with the right, but not an obligation, to buy or sell a particular currency pair at a specific exchange rate in the future.
For example, you may be in a long trade position. You want to protect against potential downside risk, while still being able to profit from your projected upwards movement in the currency pair. In this situation you might choose to purchase a put option.
If the currency pair increases in value, the put option might become worthless but you would profit from your original trade. If the currency trade moved against you and started to fall, then the put option would increase in value. This would offset your losses from the currency pair trade.
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Benefits Of Hedging With FOREX Options
When you purchase an option to hedge your financial instrument, the maximum that you can lose is the option premium. The option premium is the amount that you had to pay to buy the option. While options can limit your upside or downside risk, you have essentially an unlimited potential for profit.
Hedging price movements with options is also useful for volatile markets where you are concerned that you might get traded out of a position. For example, you might have gone long on a currency trade. You can see that there may be some volatility in the near future, but ultimately you believe that the currency pair will trend upwards.
You don’t want to set a stop-loss because you are concerned, you will be traded out of your position. Options provide an alternative to stop losses while avoiding being traded out of the position.
Hedging allows you to protect against adverse movements in your trades, while still allowing you to enjoy potentially unlimited profit on your trades. Forex options are one of the most popular ways of hedging for retail traders.
The correct amount that a trade should be hedged will depend on the trader’s risk tolerance and the individual risk of the trade. By evaluating these two factors the trader can determine how much of the trade should be hedged.
Have You Ever Hedged Your FOREX Trades?
What methods have you used…
Please leave a comment below and let me know.