How to hedge in the FX market

Share

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.

 

About the author


ModestMoney.com Top Finance Blogs

Archives

SSCP   CAS-002   9L0-066   350-050   642-999   220-801   74-678   642-732   400-051   ICGB   c2010-652   70-413   101-400   220-902   350-080   210-260   70-246   1Z0-144   3002   AWS-SYSOPS   70-347   PEGACPBA71V1   220-901   70-534   LX0-104   070-461   HP0-S42   1Z0-061   000-105   70-486   70-177   N10-006   500-260   640-692   70-980   CISM   VCP550   70-532   200-101   000-080   PR000041   2V0-621   70-411   352-001   70-480   70-461   ICBB   000-089   70-410   350-029   1Z0-060   2V0-620   210-065   70-463   70-483   CRISC   MB6-703   1z0-808   220-802   ITILFND   1Z0-804   LX0-103   MB2-704   210-060   101   200-310   640-911   200-120   EX300   300-209   1Z0-803   350-001   400-201   9L0-012   70-488   JN0-102   640-916   70-270   100-101   MB5-705   JK0-022   350-060   300-320   1z0-434   350-018   400-101   350-030   000-106   ADM-201   300-135   300-208   EX200   PMP   NSE4   1Z0-051   c2010-657   C_TFIN52_66   300-115   70-417   9A0-385   70-243   300-075   70-487   NS0-157   MB2-707   70-533   CAP   OG0-093   M70-101   300-070   102-400   JN0-360   SY0-401   000-017   300-206   CCA-500   70-412   2V0-621D   70-178   810-403   70-462   OG0-091   1V0-601   200-355   000-104   700-501   70-346   CISSP   300-101   1Y0-201   200-125  , 200-125  , 100-105  , 100-105  , 1Z0-803  , 400-051   EX300  , CISM   100-105  , 000-106   400-201   642-732   220-902   70-410  , MB6-703   810-403   70-243  , CAS-002  , AWS-SYSOPS   70-462   70-410   2V0-621   LX0-103   70-461  , 220-902   1Z0-144   70-178   70-270   350-080  , 1Y0-201   1z0-808  , NSE4   102-400  , ADM-201   SSCP  , 200-125  , 640-911   000-104   640-692   300-320   350-060   000-089  , 000-017   1z0-808   700-501   1Z0-051  , 70-177   M70-101   300-209   70-461   3002   N10-006   VCP550   70-487   300-320  , 3002   700-501   NS0-157  , 1V0-601   CAS-002