Hedging is a method used to reduce the risk of an existing investment at times of adverse movements in the market. Options are commonly used by private investors and businesses to hedge open or future deals. The latter is useful for companies who have overseas invoices to pay or profits to receive in a foreign currency.
Insuring an open forex deal
If you have an open deal and you want to lock-in the profit or limit the loss, but don’t want to close your trade, you could hedge it with an option. The effect of an option hedge is to keep the profit potential open, yet limit (hedge) any loss.
- If you are long (through buying) in the underlying market, you can hedge with a buy Put option trade. If the market falls, the Put will gain in value covering the loss from the underlying long position. If the market rises, the Put will lose to a limit whilst the value of the long position will increase with no limit.
- If you are short (through selling) in the underlying market, you can hedge with a buy Call option trade. If the market rises, the Call will gain in value covering the loss of the underlying short position. If the market falls, the Call will lose to a limit whilst the value of the short position will increase with no limit.
Limit loss example
If you held a long 100,000 AUD/USD position from 0.8000 and the current price is 0.7700, you would be at a loss of $3000 (100,000 x 0.0300). To limit further loss without closing the trade, you could hedge through buying a Put with a strike of 0.7700 and amount of 100,000 as displayed in the diagram below.
If the market price continues to go down, your long 100,000 AUD/USD position will lose $10 for every 1 point decrease in the underlying market (100,000 x 0.0001 = $10), but the Put option will gain in value and cover (or hedge) the loss. If the market rises, your AUD/USD position will profit $10 for every 1 point up, but the Put option will lose a maximum of 433.51 USD (the premium paid).
The maximum cost involved is the premium paid for the option. Always evaluate this cost, and if you expect the market to trade sideways, you may not need to hedge. The use of options is to insure an open deal when you expect adverse moves in the market.
Costs can be decreased by reducing the expiry date, reducing the amount you hedge, or choosing a strike rate worse than the underlying market rate (an out-of-the-money option). Reducing the amount or choosing a worse strike rate means you are insuring only a portion of the underlying deal’s profit. If you had chosen a strike of 0.7600 (instead of 0.7700) in the above example, your option would have cost you less but your insurance wouldn’t start until AUD/USD trades below 0.7600 hence you are putting another $1000 at risk.
Locking-in profit example
The same concept applies to locking in profit of an open deal. Using the same example as above, but instead you sold at 0.8000, you would be profiting by $3000 at 0.7700. To lock-in this profit without closing the trade, you could hedge through buying a Call with a strike at 0.7700. Thus, if the market continues to fall your underlying AUD/USD position will continue to profit. Whilst if the market turns upwards, your AUD/USD position’s profit will be reduced, but the Call option will gain in value and cover (hedge) the loss from profit.
Hedging currency rate exposure – Exporters and importers
Any company exporting and importing goods overseas will have currency rate exposure. This exposure could be on a future invoice to pay or future profits needing to be repatriated into a domestic currency. Through buying Call and Put options, a company may eliminate this risk.
For example, let’s say an Australian based travel company ‘Deluxe Travel’ has to pay a US-provider $100,000 in a month’s time. Deluxe Travel could secure a AUD/USD forward rate to sell at 0.8000, which means paying AU$125,000 for the US$100,000. Alternatively, they could buy a Put option (option to sell AUD, buy USD) with an amount of AU$125K, strike of 0.8000, and expiry of one month. It costs US$1040 to buy the Put option contract. The below image demonstrates how to set-up the option in the trading platform.
Note: The ‘amount’ of the option is entered in the amount of the first (base) currency of the pair. In this case, it is AUD.
You could view this as an insurance policy giving Deluxe Travel the right to exchange at 0.8000, but not the obligation. If the market falls, then Deluxe Travel has secured a higher rate through its option. On the other hand, if the market rises, Deluxe Travel can take advantage of the higher rate, since they are not tied into exchanging at 0.8000.
Let’s look at the savings made in these scenarios:
- AUD/USD rate falls to 0.7500 and Travel Deluxe exchanges at this lower rate, therefore paying AU$133,000 for the US$100,000. That is an extra $8,000 to pay (compared with AU$125K) , however the option pays-out a profit to cover the loss from 0.8000.
- AUD/USD rate rises to 0.8500 and Travel Deluxe exchanges at the higher rate, therefore paying only AU$117,600 for the US$100,000. That is a AU$7,400 savings compared with fixing the rate at 0.8000.
Under each of these scenarios, a premium was paid for the option. This must be considered in the hedging costs. Hedging with options may be used when you expect adverse movements or volatility in the market.