One of the most common uses for FX options among forex traders is to use them as a hedge against cash positions. Today, we’re going to look at how you might approach this.
Let’s say that GBP/USD is sitting at 1.5150 and you think it is likely to rise to 1.6500 at some point in the next month. You place a spot trade to buy GBP/USD at the market price of 1.5150, with a take-profit order at 1.6500 and a stop loss at 1.4000 to protect you from large downside risks.
Now you have a long GBP/USD position open with appropriate stop loss and take profit orders in place. You then decide to buy a one-touch option that will pay out if the price hits your stop loss of 1.4000. In order to decide how much you want to stake on this option, you need to work out how much you will lose if the spot trade hits the stop loss. Then, you need to buy an option that will pay out the same or more than this possible loss.
This means that your trade is now protected against making a loss, in that if GBP/USD falls to 1.4000, your trade will be stopped out at a loss but you will win the same amount or more from the option if this happens.
However, the flipside of this is that in order to make a profit from the cash trade, the price has to reach a point where the profit from the spot forex trade is more than the cost of the premium on the option.
So while it isn’t 100% failsafe, in that you can still make a loss if the profit on the spot trade doesn’t reach a level where it cancels out the loss on the option. As with all hedging strategies, the potential net profit from a protected trade is always much lower than it would be with one that wasn’t hedged.
However, the fact that it makes it much less likely that you will lose makes it a popular technique for forex traders, as you can always use leverage to increase the potential profitability. Whatever you do, make sure that the potential net loss on the trade is factored into your risk management strategy – just because a trade is low-risk doesn’t make it no-risk.