Hedge trading strategies forex

What is hedging as it relates to forex trading?

When a currency trader enters into a trade with the intent of protecting an existing or anticipated position from an unwanted move in the foreign currency exchange rates, they can be said to have entered into a forex hedge. By utilizing a forex hedge properly, a trader that is long a foreign currency pair, can protect themselves from downside risk; while the trader that is short a foreign currency pair, can protect against upside risk.

The primary methods of hedging currency trades for the retail forex trader is through:

Spot contracts are essentially the regular type of trade that is made by a retail forex trader. Because spot contracts have a very short-term delivery date (two days), they are not the most effective currency hedging vehicle. Regular spot contracts are usually the reason that a hedge is needed, rather than used as the hedge itself.

A forex hedging strategy is developed in four parts, including an analysis of the forex trader's risk exposure, risk tolerance and preference of strategy. These components make up the forex hedge:

Analyze risk: The trader must identify what types of risk (s)he is taking in the current or proposed position. From there, the trader must identify what the implications could be of taking on this risk un-hedged, and determine whether the risk is high or low in the current forex currency market.

The forex currency trading market is a risky one, and hedging is just one way that a trader can help to minimize the amount of risk they take on. So much of being a trader is money and risk management, that having another tool like hedging in the arsenal is incredibly useful.

Confessions of an FX Hedge Fund Trader.

by Bryan Fletcher.

I recently sat down with my colleague, Kristian Kerr of DailyFX, to interview him about his time as a former research analyst and portfolio manager at FX Concepts, previously one of the largest currency hedge funds in the world.

Kristian covers a lot of ground in this fascinating interview and it’s one you don’t want to miss.

The interview is available in audio only format or via the transcript below.

B: Hello Everyone. This is Bryan Fletcher, Product Manager for Algorithmic Trading at a major FX broker and I’m joined by Kristian Kerr of DailyFX.

K: Hi Bryan, good to be here.

B: Thanks for joining me.

B: Alright, well Kristian joins me today and I’ve been very interested in talking to Kristian about his experience working at FX Concepts. So Kristian, could you just give us a little background on what FX Concepts is and did and your experience there.

K: Yeah. FX Concepts was one of the largest currency focused hedge funds in the world. They did everything from overlay to absolute return strategies, but you know at their height, they were about a $14 Billion dollar fund. So they were kind of one of the few hedge funds out there that focused on the FX business.

B: So, what did you do specifically there? You said you were there for about 7 years?

K: Correct. I started as a research analyst covering G10 currencies and emerging market currencies and then after some time there worked my way up to proprietary trader/portfolio manager, so taking on risk on behalf of the firm.

B: Very nice. So, what can you tell me about the strategies that FX Concepts used and how did their model work? And how did you fit into that?

K: Yeah, it was primarily a systematic fund. You know, I would say about 90% of the trading was model based, systems based. There was a discretionary overlay from traders, portfolio managers, and the CIO team and that could consist of anything from trying to help on execution to overweighting a position/underweighting a position to trading instruments that you’re not getting a model signal in. It was basically just kind of a hybrid strategy to try to add alpha to the performance of the fund, which I think worked pretty well.

B: So you bring up a couple of interesting points. First, I want to ask you more about the models used by FX Concepts. Can you talk a little bit about the inputs used - price, volume, sentiment? What types of inputs were used in their models?

K: They looked at anything. They had some pretty brilliant quants that came up with them. The initial model I believe was actually cyclical. So it was based on cycle elements that John Taylor came up with, but they evolved you know with the market and developed some pretty complex type strategies. I guess their most successful model was focused primarily on the emerging markets and that’s where they had some of their best returns and they were doing some interesting things with respect to indexing and making baskets out of currencies, but you know, one of the first real funds to aggressively trade carry as well.

So it was a whole host of strategies. It’s kind of difficult to boil it down to, oh they were a trend following fund, or a counter trend following type of fund. That’s not really how it worked, but on the discretionary side they would look at all of the things you mentioned. On the systematic side, it depended on what they wanted to achieve with the strategy, but it was varied in terms of the different systems that were running at any given time.

B: So in your view, you said the discretionary overlay was there to add alpha. Can you talk about that a little bit and where do you think that comes from? What can a human do better than an algo system?

K: It’s a decision you have to make, right. That’s always a debate that we have as traders. Whether you are systematic - a lot of guys will say let the system run and have as little human input and action as possible because the whole point of a system is you want that lack of emotion in your trading, but there’s also times in the market where you know, where you can tell that the noise, that the system might not be coming at the best entry point. Things like that.

Where that little bit of human discretion…I’m not saying when you run a system you should have it 50/50 what have you, but kind of like a minor percentage overlay does help, I think, in terms of things like execution, entry points, and timing. All of those types of things, I think, are things where you can get a little bit of an extra edge if done right. Where I think you get into problems is when you try to over-optimize and the human discretionary component becomes more and more. That’s where I think you run into trouble. There’s a fine line, basically, when you’re doing this type of thing. You have to be very diligent and careful that you don’t cross the line and become too active on the discretionary side.

B: We were talking earlier about the HFT type strategies that FX Concepts employed. Can you expand a little bit about what we were discussing earlier? What models did they use and what are some of the challenges of a fund that size implementing an HFT type strategy?

K: Yeah. I mean they were relatively late to the game on high frequency stuff. It really had already started to take off, so you know, I wouldn’t say it was something they were really known for. Also, the big issue with running an HFT type strategy as a large sized fund is that it’s not scalable. The big issue is after running a bunch of tests and running through a few different strategies, they ended up finding a decent high frequency trading strategy. What ended up happening is you couldn’t run it at decent enough size to make an impact on the broader fund P/L.

I think that’s where you run into those type of issues where you can very successful trading strategies on the algo front, but if you’re running any decent size of money, it becomes very hard to kind of make that impact broader in terms of your returns if you’re running $14 billion dollars or whatever. That’s kind of the good and the bad of it. I also think that running smaller size allows you some opportunities you might not get elsewhere when you are moving the market by your size, so it’s kind of a give and take in terms of what you want to get from it.

B: FX Concepts, from what I read, was in business for 32 years and then they closed up shop not too long ago. I’m sure you’ve had a lot of time to reflect on the reasons that led to that. Can you talk about that a little bit? What do you think ultimately led to FX Concepts closing their doors?

K: Yeah, I’ve had a lot of time to think about it. You know, as I’ve said, I’m very much kind of an Austrian Economist or of that bent, where I just don’t like intervention from authorities in the market. If you’re going to run a free market system, let the market run itself, right? So I think what was very detrimental to [FX] Concepts and a lot of the other currency focused funds that ended up shutting down around this same time, it wasn’t that they made bad trades, they weren’t a Long Term Capital [Management] that really just got too big and suffered from hubris and ended up failing because they made bad trading decisions.

They were in an environment where central banking authorities and other policy makers decided to suppress volatility in the aftermath of the global financial crisis. You know vis a vis QE, vis a vis the suspension of mark to market. So we had suppression in vol[alitity]. Currency volatility fell to its lowest levels ever if you look at CVIX a couple of years ago. What ends up happening, you have the markets not moving, so pensions and those types of vehicles that invest in these products didn’t see a need to be in FX overlay or FX type of alpha seeking strategies. It just didn’t make any sense when you have a realized vol[atility] of 5% in G10. So I think that is what really undid them. Just the fact that vol[atility] just collapsed and stayed that way for a while.

Of course the interesting add on or PS to this story is that was almost - once all those funds started going out of business was almost the exact low of currency vol[atility]. You know, so it kind of goes to that idea of a Minksy moment. Stability begets instability which is what we ended up seeing and now there is a void in the market for these type of big FX hedge fund players. There’s really only a few big ones left, but I think that was really what undid them was the fact that no one saw the need for currency management anymore because vol[atility] stayed so low for so long. Obviously what ended up happening 6 months later, you had the BOJ come in doubling down with Abenomics. You saw USDJPY take off. A few months later, the SNB undid the peg in EURCHF and we had Swiss Franc move 30% in a matter of minutes.

We went from very, very extremely low levels in vol[atility] to extreme levels of volatility. There’s a lesson to be learned there I think. When things get that way you almost have to start to think contrarian because the market almost becomes too accepting of thinking that regime is going to last forever.

B: So, we were talking earlier about some scalability issues with low vol[atility]. In terms of a retail trader, should there be a fear of low vol[atility], if you’re a retail trader? What’s different that a retail trader would face as opposed to FX Concepts?

K: Yeah, not so much the vol[atility]. I would say on the retail trading side, the big difference between a big-sized trader that is going to run a system like [FX] Concepts. I mean, in some emerging markets, they were 70% of the daily volume. When you’re running that size, when you have that big of a footprint in the market, it’s a very different process that you go through because you will essentially push prices up and down going in and out of the market. Which I think ultimately it’s an advantage to being a smaller trader because you can dart in and out.

You’re that small fast boat that can go in and out of places and that’s what you’re trying to take advantage of. So, I think that’s the big difference. When you’re trading less size and I think a big thing now that’s a lot different is that the FX market has changed a lot in the last 10 years. When I first started at FX Concepts in the mid-2000s, I mean we were doing 95% of our volume voice, over the phone. When I left, 90% of the volume was being done electronically.

There was this gigantic shift in the terms of the way the FX market works and I think that really is a huge change or benefit or potential catalyst for the retail algo trader. They’ll be allowed to take advantage of some of the changes in the micro-structure of the market that frankly didn’t exist a decade ago. So I think that’s another big advantage I would say. It’s just basically the expansion of the market. It was basically very antiquated and now it’s very modern. I think that should help someone of smaller size get access to things they wouldn’t have a decade ago.

B: When the change happened from Voice to Electronic, did that impact P/L at FX Concepts in any measureable way and did that change up your strategies in any way as well?

K: Yeah, that’s a good question. Theoretically, moving to electronic, you’re supposed to improve execution costs, but you have to ask yourself at what cost, right? You know, I always tell people this, for example when I started there, Christmas time would come around and from December 1st to December 25 th , you’d walk in that office and there was literally every single space in that office would be covered by either some sort of cheese plate, cookie plate, wine bottles from banks that were giving us their thank you for the year because you are trading voice through them. When I left, we maybe got 1 bottle of wine. What I’m trying to illustrate with that point is that when you’re dealing on the voice side, you’re dealing with a relationship business, you’re talking to these people.

Who wants that type of service? It’s probably more the global macro, Soros type of fund that wants access to information. Is the guy running a system, does he need that? Probably not because his inputs are all technical, or primarily price based, you know, market focused. Not so much on flow of information. So it’s a different game, but you have to ask yourself – do you want to have both? Have a hybrid model. I know a lot of funds will still give a lot of business over voice because they want to have that liquidity access in case something happens on the electronic side.

In case you get an SNB type event, you still have relationships you can use if the electronic side goes down. That’s another reason why you’ll see that, but also they want the information. If you’re running a purely systematic fund, if that type of an event happens, you probably just shut down. You probably pull the plug for those few minutes. It’s kind of things you have to ask yourself. I don’t think there’s really a real answer, Bryan.

It kind of depends on your make up, the type of strategy you’re running and what you feel more comfortable with, but you know, I know just as many funds out there that just trade electronically and do very, very well and they don’t want, you know, it’s almost the things they talk about, the flow information ends up being noise. It all depends on what you’re trying to get from your liquidity providers.

B: I’m going to change gears a little bit. Speaking from my own experience, when I got my start trading and was trying to build an algorithmic trading strategy, I always felt like I was on the outside looking in and geez, if I just worked for one of these big players, I would know so much and it would make it so much easier to find profitable trading strategies. What are some of the takeaways that you have from working at one of the largest hedge funds out there and speaking to someone in my shoes who doesn’t have that experience, how big of an advantage is that?

K: I think we’ve kind of hit on the same theme. There’s pros and cons to size. The more money you manage, the better access you have to talent, things like that. Working with very, very smart people who can come up with solutions very easily to things, but you also give up a lot too. It becomes much more of a process – investment committees, those kinds of things. Again it’s a give and take. You want size, you don’t want size. It’s the same thing. I mean, I hear what you’re saying, but in the end, I would say I worked there 7 years and you think these big institutions have, somehow don’t suffer the same emotional pitfalls an individual trader does, or doesn’t fall under the same kind of dilemmas and traps and it’s all the same, but on a different scale.

Tudor Jones talked a lot about this in that famous PBS video, but when you’re dealing with money, in the end, the reason why I trade the way I do is that I do believe a lot of the market is about greed and fear and that’s kind of what drives us and that emotion. Just because you’re managing $14 billion dollars opposed to $1 million dollars doesn’t mean you’re not going to fall under the same pitfalls. So I would say it’s actually pretty similar, you just add a few zeroes on the ends on the trades that you’re looking at.

B: On that size of a fund, you talked about the transition from voice to electronic, how advanced were the execution algorithms for something like that.

K: It shifted with the market, right? When we first started, we were one of the first ones to use aggregation mainly because we had so many counterparty lines, so we were able to do that. We were one of the first ones to actually take advantage of some of the aggregation software. So it went from being almost we were taking advantage of the banks because we had almost a deeper knowledge of liquidity than they did to where they got more sophisticated as they started to figure out the electronic side of the business as high frequency guys left equities and started to come to FX.

The buy side went from being they’re the one in control, to, towards the end, basically banks could tell how much was behind your order, so then that game starts of basically you’ve got to splice up things and try to trick them and you get into that whole predatory flow and that’s the way I left. That’s how the markets had gotten into. Nowadays, everyone is trying to read how much is there and the market shifts almost instantaneously. It went from being very, very simple to taking advantage of to have that turned around on us when the banks basically figured it out, so to speak.

B: A couple more questions from me. What question should I have asked you that I didn’t, and what would the answer be?

K: Where’s the Euro going (laughter) or when is the Euro going to parity I would say. No, I think you hit on some really good topics here. I would just stress, and I kind of touched on it earlier, I think nowadays, given where the market has been and I’m talking FX, just this gigantic shift from being one of the most antiquated markets to being one of the more advanced now in such a short period of time that it obviously brings a lot of opportunities for kind of the retail algo trader that didn’t really exist.

There’s a lot of access here that just didn’t exist a few short years ago. I think that’s thing I would say. It’s an exciting time to be involved in this market, especially with where we’re heading. If you do think we’re in some sort of phase in terms of economic cycles, volatility, hopefully, will be here to stay. Theoretically, those using algos should be able to take advantage of it.

B: Well, good deal. Tell us, where do you want people to find you, connect with you, contact you and what are you focusing on next?

K: Yeah, I’m on DailyFX.

B: Great interview, Kristian. Thanks for your time.

K: Alright. Thanks, Bryan.

Unique experiences within this interview and past performances do not guarantee future results! Past performance is no indication of future results.

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Forex Strategy: The US Dollar Hedge.

Price action and Macro.

Trading is much more than just picking a position and ‘hoping’ that the trade works out . Trading is about risk management, and looking to focus on the factors that we know . This strategy focuses on capitalizing on US Dollar volatility, and using risk management to offer potentially advantageous setups in the market.

If there is one pervasive lesson that gets taught time and time again to traders, it’s that future price movements are unpredictable.

While this may sound foreign to ears hearing it for the first time, logic and common sense dictate as such. Human beings can’t tell the future; and our job as a trader is to try to forecast future price movements. This is where analysis comes in, hopefully offering traders an advantage. And further, this is where risk management plays an even more important role, just as we saw in our Traits of Successful Traders research in which The Number One Mistake Forex Traders Make was found to be sloppy risk management.

In this article, we are going to look at a strategy to do exactly that.

What is the USD Hedge?

The USD hedge is a strategy that can be utilized in situations in which we know the US Dollar will probably see some volatility. A good example of such an environment is Non-Farm Payrolls. With The United States reporting the number of new non-farm jobs added, quick and violent moves can transpire in the US Dollar, and as traders this is something we might be able to take advantage of.

Another of these conditions is the US Advance Retail Sales Report. This is a vitally important data print that gives considerable insight into the strongest engine of the US economy; the consumer, which accounts for roughly 65% of US economic production. This number is issued on the 13 th of the month (approximately 17.5 hours from the time this article is published for the August 2013 print), and fast moves may transpire shortly thereafter.

High impact USD events can be a great way to look for USD volatility.

Another example is Federal Reserve meetings; with a very important meeting set to come out next week as much of the world waits to hear whether or not Fed is going to begin tapering the massive easing outlays that they’ve embarked on since the financial collapse to try to keep the global economy afloat.

In all of these situations – it is absolutely impossible to predict what is going to happen.

But once again, as a trader – it is not our job to predict. It’s our job to take the one strain of information that we know will probably happen and to build an approach around that.

In the USD hedge, we look to find opposing currency pairs to take off-setting stances in the US Dollar. So, we find one pair to buy the US Dollar; and a different pair to sell the US Dollar. This way, we offset a portion of the risk of both trades by ‘trading around the dollar.’

A note on hedging.

Hedging has a dirty connotation in the Forex market. In the Forex market, hedging is often thought of as going long and short on the same pair at the same time.

This is disastrous, and an atrocity to the term ‘hedging.’ If you buy and sell the same pair at the same time, the only way you can truly profit is from the spread compressing (getting smaller), which means that your top-end profit potential is limited.

In actuality, it’s much more likely that spreads may spike during news announcements which could entail a loss on BOTH sides in this scenario.

Some traders say ‘well, I’ll close out the long at a top and wait for a bottom and then close out the short.’

This just doesn’t make sense. Because if you could time your long exit that well, then why wouldn’t you just initiate the short position there after closing the long position?

You still have to time the market in one of these ‘hedges.’ But extra risk is exposed from the fact that spreads can widen, and potentially trigger stops, margin calls, or any other number of bad events that simply aren’t worth it because there is so little upside of doing so.

The textbook definition of hedging, and this is what is taught in business schools around the world, is that a hedge is an investment that’s intended to offset potential losses or gains that may be incurred by a companion investment.

In the USD hedge strategy, that’s exactly what we’re looking to do.

What Allows the USD Hedge to W ork?

Quite simply, risk management; if we’re fairly certain that we’re going to see some US Dollar movement, we can use that in our approach to hypothesize that this movement may continue.

By looking for a 1-to-2 risk-to-reward ratio or greater ($1 risked for every $2 sought), the trader can use this information to their advantage. Advantageous risk-reward ratios are an absolute necessity in the strategy and without them – the USD hedge will not work properly. We looked at this topic in depth in the article How to Identify Positive Risk-Reward Ratios with Price Action .

The trader looks to buy the dollar in a pair, using a 1-to-2 risk reward ratio; and then the trader looks to sell the dollar in a pair, also using a 1-to-2 risk to reward ratio. The risk and reward amounts from each setup need to be roughly equal.

Risk-Reward is what allows the strategy to work properly.

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Then, when the US dollar begins its movement, the objective is for one trade to hit its stop, and the other to move to its profit target.

But because the trader is making two times the amount on the winner than they lose on the other position, they can net a profit simply by looking to utilize win-one, lose-one logic.

How to Make the Strategy Most Effective.

There are numerous ways to buy or sell US dollars, and theoretically traders could look to utilize the strategy on any of them.

But to give ourselves the best chances of success, we can integrate some of the aforementioned analysis to try to make the strategy as optimal as possible.

If I’m looking to buy the US Dollar, I want to do it against the currency that’s shown me the most weakness against the dollar of recent. And further to that point – if I’m going to sell the US Dollar I want to do it in the pairing that has shown me the most strength against the greenback.

There are quite a few ways to decide how to do this. Personally, I prefer price action. We looked at quite a few ways of doing this in The Forex Traders Guide to Price Action . Another popular, common way of doing so is by using ‘ strong-weak analysis .’ Since we have the constant of the US Dollar in all observed pairs, we can simply grade currency strength by comparing relative performance to the US Dollar. In the recent article Strong & Weak , Jeremy Wagner looked at exactly that process.

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Forex Hedging: How to Create a Simple Profitable Hedging Strategy.

Ultimately to achieve the above goal you need to pay someone else to cover your downside risk.

In this article I’ll talk about several proven forex hedging strategies. The first section is an introduction to the concept which you can safely skip if you already understand what hedging is all about.

The second two sections look at hedging strategies to protect against downside risk. Pair hedging is a strategy which trades correlated instruments in different directions. This is done to even out the return profile. Option hedging limits downside risk by the use of call or put options. This is as near to a perfect hedge as you can get, but it comes at a price as is explained.

What Is Hedging?

Hedging is a way of protecting an investment against losses. Hedging can be used to protect against an adverse price move in an asset that you’re holding. It can also be used to protect against fluctuations in currency exchange rates when an asset is priced in a different currency to your own.

When thinking about a hedging strategy it’s always worth keeping in mind the two golden rules :

Hedging might help you sleep at night. But this peace of mind comes at a cost. A hedging strategy will have a direct cost. But it can also have an indirect cost in that the hedge itself can restrict your profits.

The second rule above is also important. The only sure hedge is not to be in the market in the first place. Always worth thinking on beforehand.

Simple currency hedging: The basics.

The most basic form of hedging is where an investor wants to mitigate currency risk. Let’s say a US investor buys a foreign asset that’s denominated in British pounds. For simplicity, let’s assume it’s a company share though keep in mind that the principle is the same for any other kind of assets.

The table below shows the investor’s account position.

Without protection the investor faces two risks. The first risk is that the share price falls. The second risk is that the value of the British pound falls against the US dollar. Given the volatile nature of currencies, the movement of exchange rates could easily eliminate any potential profits on the share. To offset this, the position can be hedged using a GBPUSD currency forward as follows.

In the above the investor “shorts” a currency forward in GBPUSD at the current spot rate. The volume is such that the initial nominal value matches that of the share position. This “locks in” the exchange rate therefore giving the investor protection against exchange rate moves.

At the outset, the value of the forward is zero. If GBPUSD falls the value of the forward will rise. Likewise if GBPUSD rises, the value of the forward will fall.

The table above shows two scenarios. In both the share price in the domestic currency remains the same. In the first scenario, GBP falls against the dollar. The lower exchange rate means the share is now only worth $2460.90. But the fall in GBPUSD means that the currency forward is now worth $378.60. This exactly offsets the loss in the exchange rate.

Note also that if GBPUSD rises, the opposite happens. The share is worth more in USD terms, but this gain is offset by an equivalent loss on the currency forward.

In the above examples, the share value in GBP remained the same. The investor needed to know the size of the forward contract in advance. To keep the currency hedge effective, the investor would need to increase or decrease the size of the forward to match the value of the share.

As this example shows, currency hedging can be an active as well as an expensive process.

Hedging Strategy to Reduce Volatility.

Because hedging has cost and can cap profits, it’s always important to ask: “why hedge”? For FX traders, the decision on whether to hedge is seldom clear cut. In most cases FX traders are not holding assets, but trading differentials in currency.

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Carry traders are the exception to this. With a carry trade, the trader holds a position to accumulate interest. The exchange rate loss or gain is something that the carry trader needs to allow for and is often the biggest risk. A large movement in exchange rates can easily wipe out the interest a trader accrues by holding a carry pair.

More to the point carry pairs are often subject to extreme movements as funds flow into and away from them as central bank policy changes (read more).

To mitigate this risk the carry trader can use something called “reverse carry pair hedging”. This is a type of basis trade. With this strategy, the trader will take out a second hedging position. The pair chosen for the hedging position is one that has strong correlation with the carry pair but crucially the swap interest must be significantly lower.

Carry pair hedging example: Basis trade.

Take the following example. The pair NZDCHF currently gives a net interest of 3.39%. Now we need to find a hedging pair that 1) correlates strongly with NZDCHF and 2) has lower interest on the required trade side.

Using this free FX hedging tool the following pairs are pulled out as candidates.

The tool shows that AUDJPY has the highest correlation to NZDCHF over the period I chose (one month). Since the correlation is positive, we would need to short this pair to give a hedge against NZDCHF. But since the interest on a short AUDJPY position would be -2.62% it would wipe out most of the carry interest in the long position in NZDCHF.

The second candidate, GBPUSD looks more promising. Interest on a short position in GBPUSD would be -1.04%. The correlation is still fairly high at 0.7137 therefore this would be the best choice.

We then open the following two positions:

The volumes are chosen so that the nominal trade amounts match. This will give the best hedging according to the current correlation.

Figure 1 above shows the returns of the hedge trade versus the unhedged trade. You can see from this that the hedging is far from perfect but it does successfully reduce some of the big drops that would have otherwise occurred. The table below shows the month by month cash flows and profit/loss both for the hedged and unhedged trade.

Carry hedging with options.

Hedging using an offsetting pair has limitations. Firstly, correlations between currency pairs are continually evolving. There is no guarantee that the relationship that was seen at the start will hold for long and in fact it can even reverse over certain time periods. This means that “pair hedging” could actually increase risk not decrease it.

For more reliable hedging strategies the use of options is needed.

Buying out of the money options.

One hedging approach is to buy “out of the money” options to cover the downside in the carry trade. In the example above an “out of the money” put option on NZDCHF would be bought to limit the downside risk. The reason for using an “out of the money put” is that the option premium (cost) is lower but it still affords the carry trader protection against a severe drawdown.

Selling covered options.

As an alternative to hedging you can sell covered call options. This approach won’t provide any downside protection. But as writer of the option you pocket the option premium and hope that it will expire worthless. For a “short call” this happens if the price falls or remains the same. Of course if the price falls too far you will lose on the underlying position. But the premium collected from continually writing covered calls can be substantial and more than enough to offset downside losses.

If the price rises you’ll have to pay out on the call you’ve written. But this expense will be covered by a rise in the value of the underlying, in the example NZDCHF.

Hedging with derivatives is an advanced strategy and should only be attempted if you fully understand what you are doing. The next chapter examines hedging with options in more detail.

Downside Protection using FX Options.

What most traders really want when they talk about hedging is to have downside protection but still have the possibility to make a profit. If the aim is to keep some upside, there’s only one way to do this and that’s by using options .

When hedging a position with a correlated instrument, when one goes up the other goes down. Options are different. They have an asymmetrical payoff. The option will pay off when the underlying goes in one direction but cancel when it goes in the other direction.

First some basic option terminology. A buyer of an option is the person seeking risk protection. The seller (also called writer) is the person providing that protection. The terminology long and short is also common. Thus to protect against GBPUSD falling you would buy (go long) a GBPUSD put option. A put will pay off if the price falls, but cancel if it rises.

On the other hand if you are short GBPUSD, to protect against it rising, you’d buy a call option.

For more on options trading see this tutorial.

Basic hedging strategy using put options.

Take the following example. A trader has the following long position in GBPUSD.

The price has already fallen since he entered so the position is now down by $70.

The trader wants to protect against further falls but wants to keep the position open in the hope that GBPUSD will make a big move to the upside. To structure this hedge, he buys a GBPUSD put option. The option deal is as follows:

Trade: Buy 0.1 x GBPUSD put option.

The put option will pay out if the price of GBPUSD falls below 1.5000. This is called the strike price . If the price is above 1.500 on the expiry date, the put option will expire worthless.

The above deal will limit the loss on the trade to 100 pips. In the worst case scenario the trader will lose $190.59. This includes the $90.59 cost of the option. The upside profit is unlimited.

The option has no intrinsic value when the trader buys it. This is an “out of the money” option. The time value, or premium is there to reflect the fact that the price may fall and the option could therefore go “in the money”.

The trader pays $90.59 for this privilege of gaining downside protect. This premium goes to the seller of the option (the writer).

Note that the above structure of a put plus a long in the underlying has the same pay off as a long call option.

The table above shows the pay outs in three different scenarios: Namely the price rising, falling or staying the same. Notice that the price has to rise slightly for the trader to make a profit in order to cover the cost of the option premium.

To help you test the trading ideas presented here the following free downloads are provided:

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Hi Seyedmajid – is it possible to share your experiences.

i have made a winning hedging strategy that always make profit no matter where market is going…

this is my ultimate strategy after 8 years of trading.

can you share bro.

super article on hedging and thoroughly explained.. thanks steve.