Forex hedging is a technique used to shield one’s position against an adverse move in a currency pair. When a trader is worried about news or an event causing volatility in currency markets, it is usually a means of short-term security. When talking about hedgeing forex pairs in this way, there are two linked strategies. One is to put a hedge in the same currency pair by taking the opposite spot, and the second solution is to purchase forex options.

First choice

By holding both a short and a long position simultaneously on the same currency pair, a forex trader may build a’ hedge’ to completely protect an established position from an adverse change in the currency pair. This variant of a hedging strategy is referred to as a “perfect hedge” since, while the hedge is working, it removes all the risk (and thus all the possible profit) associated with the trade.

While it might sound bizarre to sell a currency pair that you keep long, since the two opposing positions balance one another, it is more normal than you would expect. This kind of “hedge” also occurs when a trader holds a long or short position as a long-term trade and opens an opposite trade to build the short-term hedge in advance of important news or a big event instead of liquidating it.

Interestingly, this form of hedging is not allowed by forex dealers in the United States. By treating the conflicting trade as a “close” order, firms are instead forced to net out the two positions. The outcome of a “netted-out” trade and a hedged trade, however, is exactly the same.

Second choice

A forex trader may build a “hedge” using forex options to partially safeguard an existing position against an adverse change in the currency pair. The strategy is referred to as an’ imperfect hedge’ since only some of the risk (and thus only some of the potential profit) associated with the transaction is typically eliminated by the resulting position.

A trader who is long a currency pair can buy put option contracts to maximize downside risk in order to build an incomplete hedge, whereas a trader who is short a currency pair can buy call option contracts to decrease the risk resulting from a move to the upside.

 

Downside Risk Hedges

Put options contracts offer the buyer the right, but not the duty, to sell a currency pair at a given point (strike price) on, or before, a certain date (expiration date) to the options seller in return for the payment of an upfront premium.

For instance, suppose a forex trader is long EUR/USD at 1.2575, expecting the pair is going to move higher but is also worried the currency pair may move lower if an upcoming economic announcement turns out to be bearish. The trader could hedge risk by buying a put option contract with a strike price somewhere below the current exchange rate, like 1.2550, and an expiration date sometime after the economic announcement.

If the announcement comes and goes, and EUR/USD doesn’t move down, the trader will hang onto the long EUR/USD trade, potentially making additional gains the higher it goes. Keep in mind, the short-term hedge at the cost of premium charged for the put option deal.

If the announcement comes and goes, and EUR/USD starts heading lower, the trader does not need to worry too much about the bearish move because the put limits some of the risk. After the long put is opened, the risk is proportional to the distance between the value of the pair at the time of purchase of the options contract and the strike price of the option, or 25 pips in this case (1.2575 – 1.2550 = 0.0025), plus the premium charged for the options contract. And if EUR/USD fell to 1.2450, the maximum loss is 25 pips, plus the premium, since the put can be exercised at the 1.2550 price regardless of what the market price for the pair is at the moment.

 

Upside Risk Hedges

In exchange for an upfront premium, call options contracts give the buyer the right, but not the obligation, to buy a currency pair at a strike price or before the expiration date.

Let say a forex trader who is short GBP/USD at 1.4225, expecting the currency pair to fall, but at the same time is concerned that the currency pair may rise if the upcoming Parliamentary vote is bullish. You can mitigate a portion of the risk by purchasing a call option contract with a strike price above the current exchange rate, such as 1.4275, and an expiration date after the scheduled vote.

Now, should the vote does not result in a higher GBP/USD, the trader will leave the short GBP/USD position free, profiting as the price falls. The short-term hedge costs are equal to the premium charged for the call option bid, which is forfeited if the GBP/USD persists over the strike and the call expires.

If the vote passes and the GBP/USD continues to increase, the seller does not need to be worried with the bullish move because, due to the call option, the risk is limited to the gap between the pair’s valuation before the options were acquired and the option’s strike price, or 50 pips in this situation (1.4275 – 1.4225 = 0.0050), plus the premium charged for the options contract.

And if the GBP/USD increases to 1.4375, the ultimate risk is just 50 pips plus the premium so the call can be exercised to buy the pair at the 1.4275 strike price and then protect the short GBP/USD position, regardless of the actual market price.