| Forex Options Part 4: Protective Forex Options |
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Frequently you will hear traders, especially on the institutional side, talk about hedging some of their market exposure on a particular position. Every good trader learns to minimize risk through hedges.
You can use forex options to reduce your total exposure to market risk. For example, if you are long a particular currency pair, and want to cover some of your risk without using a stop loss, you may decide to buy a bearish option (put). Likewise, if you are short a currency pair and want to hedge some risk, a long call can be used. In this section we will talk about why you might want to do that and how it works. {mos_fb_discuss: 26}
Buying a hedge or protective option is something that traders do when they think that risk is rising in a particular position, and they want some coverage against loss, but do not want to use a stop loss, which may whip them out of the position early. In the example below from December of ’07, you can see the GBP/USD has bounced up to the 23.6% Fibonacci level (see our Fibonacci course for more details) at 2.0461. If you had been in a short position on the GBP/USD, trading the fundamental decline in the GBP/USD, you might have decided to use a 100 pip stop loss at the next Fibonacci level to protect your short position from excessive losses. But the risk of a whipsaw in that position is great. So instead, let’s see what would have happened if you had used a protective option.
In this case, you would have bought a call as a hedge. A call is a bullish option that will act to limit losses on your short forex position. In this case, we will assume that you purchased a call option with a strike price of 2.0500. This option is a little out of the money, as the current price is lower than the strike price, so it’s less expensive than an in-the-money option because it currently has no intrinsic value. In this case, the call would have cost $100 for a $10,000 lot. {mosloadposition contentad}
Ideally, you would like your short spot position to profit, as the pair continues to decline. But the option provides cover for you, if the price of the pair were to suddenly turn around. In fact, in this case, no matter how high the market rises against your short position, you cannot lose anything more than the cost of your protective call option, plus the difference between the current exchange rate price and the strike price. That is because the option will increase in value as the market rises. Its intrinsic value will grow pip for pip as it goes in the money. Let’s assume that the worst case scenario occurred and the market moved up 500 pips against our position by the call’s expiration date.
Now, this is certainly more expensive than the stop loss. But when you look at how this trade worked out, your perspective of cost may change.
In the image below you can see that alternative #1, the stop loss, was triggered for a $100 loss. It’s a classic whipsaw.
But Option 2 shows us, if you had purchased a call option to cover the position instead of a stop, you would have remained in the trade and made 261 pips. But that’s not all. You could also have sold the call on the subsequent downside breakout for its remaining value of $25 once the market hit 2.0200. Essentially you spent $75 to cover yourself against losses while the market was at resistance, and you avoided the whipsaw that, with a stop, would have taken you out and cost you the 261 pip gain when the trade moved in your direction.
In the video we will look at the opposite scenario: Buying a put to cover or hedge a long spot forex position.
Before we look at the video, here are are a couple of important tips for learning to apply this options hedging strategy.
Watch the video below, then proceed to the next lesson: Selling Options
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3.25 Copyright (C) 2007 Alain Georgette / Copyright (C) 2006 Frantisek Hliva. All rights reserved." |
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