When you open a position in a currency pair, you obviously want the price to move in the right direction. For example, if you take a long position in EUR/USD, you want the euro to rise against the US dollar. However, if the euro falls against the greenback, then you stand to lose money.
Hedging is a way of protecting yourself from this downside risk. It essentially acts as insurance, offsetting your losses if the currency pair moves in the wrong direction. One of the most popular ways of buying this insurance is by investing in foreign currency options. A foreign currency option gives you the right, but not the obligation, to sell or buy a currency pair at a specific exchange rate over a certain period of time. The price you can buy or sell at is known as the strike price.
How hedging works
Let’s assume you buy EUR/USD at 1.14 on the spot market in the expectation that the euro is going to go up against the US dollar. You want to protect yourself in case the euro actually falls. To do this, you buy what is called a put option – this is an option that gives you the right to sell the currency pair in the future.
For the sake of simplicity, let’s assume that future strike price is 1.14. If the euro does go up – say to 1.17 – then you will make money on the spot market position you opened – 0.03, in fact. However, the option you bought will be worthless – there’s no value in selling at 1.14 if the price is 1.17. On the other hand, if the euro goes down – say to 1.12 – then you’ll lose 0.02 on your spot market position. However, this will be offset by your put option’s payout, since you have the right to sell at 1.14 even though the price is 1.12.
Similarly, if you short EUR/USD, then you want the price to go down. If the price goes up, then you will lose money. However, you may protect against this by buying a call option, which gives you the right to buy as a particular strike price in the future. If the price does go up, you’ll lose on your spot market position, but you’ll make it back on the call option’s payout.
Hedging doesn’t create risk-free trades
You have to pay a premium to buy an option hence although it can reduce risk it is not entirely risk free! One of the factors determining the price of an option is the difference between the current currency pair price and the strike price. The further away your strike is from the current price of the currency pair (and at a worse price) the cheaper the option is to buy.
However, the price of an option is also affected by the length of time until it expires and the markets expected volatility. This is known as the time value, and contributes to the premium you pay for your insurance. The longer the duration of an option and/or if more volatility is expected in the currency pair over that duration the more expensive the option will be. So, as with all trading, there is no such thing as a free lunch when you hedge your forex positions.
Source:: A Beginner’s Guide to Hedging