Hedging is a topic often asked about by advanced learners. In this article, we want to clarify whether and when it makes sense to take a closer look at the complex subject of hedging.
What is hedging?
Hedging means protection. You want to protect your existing positions. This can be done directly at the start of the trade or afterwards. Hedging always involves costs. Either you pay directly, for example, when buying an option, the option premium or you indirectly pay money by cutting the profits of the original position.
Classic hedge with options
A classic hedge with options looks like this:
- Imagine you are long in EURUSD and you want to hedge against falling prices. Then you can do this with a bought put on EURUSD. This put costs money, the so-called option premium. If EURUSD goes further, you will earn money in your original position, but lose the option premium paid. But if EURUSD falls, then with your put option you have the right to sell EURUSD at a pre-determined price.
- Imagine you are short in EURUSD and you want to hedge against rising prices. Then you can do this with a purchased call on EURUSD. This call costs money, the so-called option premium. If EURUSD continues to fall, then you will earn money in your original position, but lose the option premium paid. But if EURUSD rises, then with your call option you have the right to buy EURUSD at a pre-determined price.
Concrete numerical examples for hedging with options
Suppose you are long in EURUSD at 1.1188 and you want to hedge against falling prices at the same time and buy a put, then this put with a strike of 1.1175 (right to sell this value) at a term from 17 days about $360. If EURUSD now falls to 1.1000 or even 0.9000, then the buyer of this put has the right to sell EURUSD at 1.1175.
Of course, other strikes and maturities are available and can be chosen freely.
Why not use a normal stop loss?
There is absolutely nothing to be said against setting a normal stop loss. On the contrary, it costs nothing at all. Nevertheless, there are certain disadvantages compared to an option for protection:
- A stop loss is triggered when the stop loss level is reached. If the position then develops again in the desired direction, you no longer participate in it.
- A stop loss can lead to such an increased spread and too high slippage, especially in heavy market phases. The desired stop loss course is not guaranteed.
- Gaps, as they can appear at the weekend, lead to a significantly worse execution (indirect high slippage).
For whom is a hedge with options worthwhile?
Basically, it is not recommended to hedge all positions constantly. There are a few targeted spots and news events to use to actively buy options as a hedge.
Hedging with options is only useful for:
- Large accounts that can hedge real futures contracts with real options
- Positions that tend to seek a longer duration. In very few cases, intraday positions can be protected with purchased options.
Hedge small accounts with options
Since an option always covers a complete futures contract and not just fractions of it, you can only trade options as a hedging instrument with large accounts. Assuming that you trade CFDs on EURUSD and have a position size of 4 mini lot, that is, a 0.4 lot, this equals only 40% of a complete lot. If you now want to buy an option to hedge, then you overhedge and build up an additional risk.
Other variants of hedging
There are also many other ways to hedge positions. It does not always have to be an option, and it can also protect positions in smaller accounts that trade CFDs. At this point, the length of the article would go beyond our scope, and in this article we have focused on the subject of hedging with options in currency trading due to targeted enquiries from our premium members. Nonetheless, we want to encourage thought with two key phrases:
- Correlating positions
- Sale of options
