Is There Such a Thing as Hedging in the Forex Market?
The foreign currency exchange (Forex) market involves almost $4 trillion in trades every business day. Currencies are traded in pairs in which the trader is long (or owns) the numerator, or base, currency and is short (or sells) the denominator, or counter, currency. Hedging, which is frequently used in Forex markets, is the partial offset of one trading position with another. If a currency pair position declines in value, a hedger hopes to counter the loss with a gain in a hedging position. There are several ways to obtain a Forex hedging position, but to understand hedge techniques you must first understand Forex pricing.
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Forex Pricing
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To illustrate pricing, assume a trader owns a position in the currency pair EUR/USD (euro vs. U.S. dollar) with a current price ratio of 1 euro per 1.5 U.S. dollars, giving a four-decimal price of 1.5000. A price increase would mean the trader could buy more dollars per euro, so a new price of 1.5020 would yield a profit of .0020, known to traders as 20 pips, or points in percentage. You would multiply the size of the position by .0020 to calculate the profit. A standard lot is $100,000, so 20 pips would yield a profit of $200.
Pairs Hedging
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In our example, the trader actually suffers a 20 pips price decline to 1.4080 for the EUR/USD currency pair, costing the trader $200. To attempt to hedge against this loss, the trader might take on a hedging position: short EUR and long some other currency, such as the British pound (GBP). For ease, assume that the GBP to EUR ratio is one to one--the price of the GBP/EUR currency pair is 1.0000. If GBP/EUR rose by 10 pips as the EUR/USD dropped 20, the trader would net only a 10-pip loss, or $100. The other $100 previously lost by the EUR/USD trade alone is partially offset by the $100 gain in GBP/EUR currency pair.
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Hedging with Currency Options
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Our example hedge worked nicely, but it might not have. For instance, had the British pound also declined in value, the overall GBP/EUR price of 1.0000 might have remained steady, affording the trader no offset to the EUR/USD price decline. An alternative hedging method involves purchasing foreign currency options--contracts that confer the right, but not the obligation, to buy (via a call option) or sell (via a put option) a specified amount of a foreign currency by a certain date for a pre-established price (the strike price). Our example trader could hedge against a decline in the euro by purchasing put options on the euro. As the euro dropped 20 pips in price, the euro put might gain 12 pips in value, thus partially hedging against a loss in the currency pair position.
Hedging with Binary Options
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A third hedge technique uses binary options to offset price risk. Binary options trade on the National Derivatives Exchange (NADEX), and they essentially are all-or-nothing bets that a currency pair will achieve a certain strike price within a certain time frame. Each option pays $100 if the strike price is reached, otherwise it expires worthless. In our example, the trader could have purchased two EUR/USD binary puts at $20 each with a strike price of 1.4083. Since the price dropped to 1.4080, the binary puts paid off, providing a net hedge of $160 gained against a $200 loss on the EUR/USD currency pair.
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