Forex options hedging strategy
A currency option gives the holder the right, but not the obligation, to exchange a currency pair at a given price before a set time of expiry. Options are extremely popular hedging tools, as they give you the chance to reduce your exposure while only paying for the cost of the option.
Let’s say you’re long on AUD/USD, having opened your position at $0.76. However, you are expecting a sharp decline and decide to hedge your risk with a put option at $0.75 with a one-month expiry.
If - at the time of expiry - the price has fallen below $0.75, you would have made a loss on your long position but your option would be in the money and balance your exposure. If AUD/USD had risen instead, you could let your option expire and would only pay the premium.
How to hedge forex
Hedging strategies are often used by the more advanced trader, as they require fairly in-depth knowledge of financial markets. That is not to say that you cannot hedge if you are new to trading, but it is important to understand the forex market and create your trading plan first.
Learn more in our beginners’ guide to forex trading
Perhaps the most important step in starting to hedge forex is choosing a forex pair to trade. This is very much down to your personal preference, but selecting a major currency pair will give you far more options for hedging strategies than a minor. Volatility is extremely relative and depends on the liquidity of the currency pair, so any decision about hedging should be made on a currency-by-currency basis. For example, a major pair such as GBP/USD will likely see far more volatility in a day than an exotic pair like USD/HKD.
Other considerations should include how much capital you have available – as opening new positions requires more money – and how much time you are going to spend monitoring the markets.
Start hedging forex
You can test out your hedging strategies in a risk-free environment by opening a demo trading account with IG. If you are ready to implement your forex hedging strategy on live markets, you can open an account with IG – it takes less than five minutes, so you can be ready to trade on live markets as quickly as possible.
Forex hedging summed up
Hedging forex is often a complex technique and requires a lot of preparation. Here are some key points for you to bear in mind before you start hedging:
- Forex hedging is the practice of strategically opening new positions in the forex market, as a way to reduce exposure to currency risk
- Some forex traders do not hedge, as they believe volatility is part of the experience of trading forex
- There are three popular hedging strategies: simple forex hedging, multiple currencies hedging and forex options hedging
- Before you start to hedge forex, it is important to understand the FX market, choose your currency pair and consider how much capital you have available
- It is a good idea to test your hedging strategy before you start to trade on live markets
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