How to hedge in the FX market

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Whether you are an institutional trader managing a large portfolio, or an individual trader, you might have had the need to hedge your currency exposure in one way or another. Opening an account with a reputable forex broker and placing some trades is one, but there are many other alternatives as well.

Most instruments and types of instruments (like CFDs, futures, options etc) came about in order to hedge some form of exposure, to negate risk. As the markets and trading evolved, many instruments became favorites of speculators and traders apart from being effective tools to hedge.

The first and simplest way is to open an account, and place a trade in the desired currency pair. This is usually a “spot” trade. In the case of an EUR/USD long for example the trader sells USD in order to buy EUR. A favorable setup for someone who needs to “lock in” a rate. As long as the position is open the trader does not have to worry about the market moving in any direction, since his exposure is limited.

In the meanwhile he has to pay financing. This is due to the fact, that most brokers offer leverage when trading, and only a certain amount of margin is required to place the trade. A 100:1 leverage is very common, meaning that for every $1000 account balance it is possible to buy or sell $100,000 worth of currencies. $99,000 of that is borrowed, for which the trader has to pay interest if the position is held overnight.

The last factor to take into consideration is the difference in base interest rates of the two currencies. If the bought currency has a higher interest rate than the sold currency, then it is even possible to actually receive income from keeping positions open overnight, regardless of the financing charge. Keeping a position open for the sole purpose of receiving interest is known as “carry trading” and is a widely used tactic for investors large and small.
A famous example for that was the EUR/CHF pair up until January 2015. The Swiss National bank pegged the exchange rate to 1.20. This made traders to believe that there is no/little downside risk with all the benefits of collecting the difference in interest rates every single day. We all saw where that led to, so a trader ought to be very careful when placing a position like this.

Another possibility for hedging currency exposure is to buy FX options. Most forex brokers have them available on their trading platforms. Options have two basic types: calls and puts. Buying a call option gives the trader the right, but no obligation, to buy the underlying currency pair for the strike price before expiration. Being long, or buying a put, gives the trader the right, but no obligation, to sell the underlying currency pair for the strike price before expiration.

The price of the underlying instrument compared to the strike price leaves us with further categorization: In the money, at the money, or out of the money options. In the money options have intrinsic value and time value. A call with a strike price of 0.90 for the EUR/USD is currently well in-the-money as the spot is at 1.12. An at the money option would be a strike price of 1.12, and an out of the money option means a strike price above (or below for puts) current market price. At-the-money and out of the money options only have time value.

A very important fact to remember is that options have an expiry. Even in the money options have some part of time value in their price apart from the intrinsic value, but the most dramatic change can be observed with at the money options. Time value decays every single day more and more as the expiry date approaches. This is why options are called “wasting assets”.

In order to create the same hedge as we discussed before (going long the EUR/USD) a trader needs to simply buy a call option with the desirable strike price and expiration date. Time decay does not play too much of a role in this case, since the resale of a hedge is usually not a concern. The premium of an option does matter however, as this is the “cost” of hedging, and a too large premium will make the hedge too expensive, rendering it useless. Like an insurance premium, the cost has to be reasonable enough to warrant the purchase.

Whether buying options or trading the spot markets it is very important to choose a dependable forex broker which lets the trader execute the trades flawlessly and with the best possible conditions. Hedging is an interesting aspect of trading, and with the proper setup it can easily remove the uncertainty of the wildly fluctuating foreign exchange markets and exchange rates. Sometimes that is all that is required.

 

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