An excellent means of hedging Forex trades are Forex options. Companies that do business internationally typically use Forex options to guard against the currency risk entailed in foreign transactions. 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. Calls and puts work for hedging Forex trades and guarding against losses when speculating in either up or down markets.
Calls and Puts in Forex Trades
In Forex trading one thinks in terms of the base currency and the quote currency. When a trader purchases Canadian dollars with US dollars the US dollar is the base currency and the Canadian dollar is the quote currency. In hedging Forex trades with options think in terms of a call on the quote currency purchased with the base currency. 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 with US dollars. He will pay the options contract premium with and do his accounting in US dollars. With a put in hedging Forex trades the trader likewise purchases the put on the quote currency using the base currency. But what do calls and puts allow a trader to do in hedging Forex currencies?
Purchasing a Right and Not an Obligation
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. They are never under any obligation to do so. 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. 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. The call contract gives a trader the right to purchase at the contract price which is also called the strike price. He or she will only execute the contract if the quote price does rise. An alternative is to simply exit the trade by selling the now more valuable contract and pocket a profit. 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. 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.
Hedging Forex Trades
Why not just buy and sell currencies? What is the point of hedging Forex trades? There are a couple of reasons. 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. 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. 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. He or she does not tie up a lot of cash buy purchasing the quote currency and then waiting for a change. He or she simply pays a small amount to reserve the right to make a trade. This is the leverage inherent in options trading and is often the reason for hedging Forex trades with options.