Forex Trading Strategies: Hedging
Hedging simply means protecting one’s investment from unwanted moves. For example, you have initiated long contract on EUR/USD pair, thinking that USD will appreciate. Later, the GDP data of US comes out much worse than expected, resulting in sharp downward moves in the EUR/USD forex pair. Unfortunately, this will put pressure on your long and you could run into huge losses. To stay away from such huge losses, forex traders can employ hedging strategies using the mt4 forex trading platform.
Consideration before hedging:
Before jumping onto hedging, trader should consider following four elements:
- Understand: It is important to understand the level-of-risk being taken.
- Estimate: Individual must know the amount of money they can jeopardize, and also the premium they are ready to pay to minimize the risk.
- Identify: Identify cost-efficient strategy, to be deployed for hedging their trade.
- Apply and observe: Apply and monitor the strategy to monitor its intended implications.
Let’s say you initiate a trade of 1 lot (10000 units) by buying a EUR/USD contract, meaning Buying EUR/Selling USD, at a strike price of 1.35815, thinking that Euro will strengthen against USD. You don’t want to take risk, and hence deploy hedging strategy by buying 1 lot put option of EUR/USD at a premium of 0.0005, of 1.35 strike price (premium 5$).
|Rise (1pip)||Fall (1 pip)|
|Put option premium @ 0.0005||5.0$||5.0 $|
|Un-hedged profit||100 $||100 $|
|Option price at trade execution||0.0000||0.00185|
|Option price at the end||0.0000||18.5 $|
|Hedged profit/loss||95 $||86.5 $|
The table indicates two scenarios where prices moves favorably/unfavorably by 1 pips. If the prices move on expected lines, then the option price at maturity date becomes zero, implying a profit of $ 95. But if prices move unfavorably, then the option price becomes the difference of option strike price and the future price at maturity, resulting a profit of $18.5 from option strategy, and overall losses become only 86.5 $.
Thus a hedging strategy of buying option against future contract saved you valuable 13.5$ from the trade. Prudent hedging strategy can limit the amount of risk being taken considerably, compared to unhedged trading.