Hedging Forex Trades

http://www.theforexnittygritty.com/forex/hedging-
forex-trades
An excellent means of hedging Forex
tradesare Forex options.

forex-trades
Companies that do business internationally
typically use Forex options to guard
against the currency risk entailed in foreign
transactions.

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However, hedging currency trades need not
be limited to a company in Ohio that is
purchasing machine parts from a German
distributor or a Japanese company that is
buying processed poultry in bulk from a
company in Missouri.

forex-trades
Calls and puts work for hedging Forex
trades and guarding against losses when
speculating in either up or down markets.

forex-trades
Calls and Puts in Forex Trades

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In Forex trading one thinks in terms of the
base currency and the quote currency.

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When a trader purchases Canadian dollars
with US dollars the US dollar is the base
currency and the Canadian dollar is the
quote currency.

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In hedging Forex trades with options think in
terms of a call on the quote currency
purchased with the base currency.

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If and when the buyer of a call contract on
the Canadian dollar with US dollars
executes the contract, he will go ahead
and purchase Canadian dollars withUS
dollars.

forex-trades
He will pay the options contract premium
with and do his accounting in US dollars.

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With a put in hedging Forex trades the
trader likewise purchases the put on the
quote currency using the base currency.

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But what do calls and puts allow a trader to
do in hedging Forex currencies?

forex-trades
Purchasing a Right and Not an Obligation

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When buying options traders pay for the
right to buy in the case of a call contract
and sell in the case of a put contract.

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They are never under any obligation to do
so.

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Rather a trader will carry out fundamental
and technical analysis of Forex currencies
and decide that a quote currency is likely
to go up or down in relation to the base
currency.

forex-trades
If the quote currency is like to go up in
relation to the base currency he or she
buys a call contract and if he believes that
the quote currency will fall he will buy a put
contract.

forex-trades
The call contract gives a trader the right to
purchase at the contract price which is also
called the strike price.

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He or she will only execute the contract if
the quote price does rise.

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An alternative is to simply exit the trade by
selling the now more valuable contract and
pocket a profit.

forex-trades
In the case of a put the trader expects the
quote price to fall and he purchases a put
option which gives him the right to sell the
quote currency for the base currency which
he will do only if the price does, in fact, fall.

forex-trades
And, as with a call contract, he or she can
always simply exit the trade with a profit by
selling the no more valuable options
contract.

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Hedging Forex Trades

forex-trades
Why not just buy and sell currencies?

forex-trades
What is the point of hedging Forex trades?

forex-trades
There are a couple of reasons.

forex-trades
The first is that when trading a volatile Euro,
US dollar or British Pound there may be
profits to be made as well as losses to be
incurred.

forex-trades
The point of hedging is that one pays a
premium for the insurance of being able to
make a profitable trade if conditions
become favorable while putting an exact
limit on the cost and risk of the transaction.

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The other reason for hedging Forex trades is
that often times a trader can get into a very
cheap call or put contract and make a
substantial profit.

forex-trades
He or she does not tie up a lot of cash buy
purchasing the quote currency and then
waiting for a change.

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He or she simply pays a small amount to
reserve the right to make a trade.

forex-trades
This is the leverage inherent in options
trading and is often the reason for hedging
Forex trades with options.

Hedging Forex Trades

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