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Currency Options Hedge Strategy

OK, now I thought long and hard about this page, and the sort of examples that I could give you which would help explain how to use currency options alongside your spot fx trading in order to combine the best of both worlds. As some of you may know I love writing covered calls using equity options, and have a site which covers this strategy in detail for equity options. This is how I use the covered call in currency trading which I think is a perfect example of how to use the currency option as a hedge.

So, for those of you familiar with writing covered calls on stocks, this will be very familiar territory for you – for those of you who have never traded this strategy, please just take a few minutes over on the covered call writing site which will give you all the information you need, and I hope will help in understanding how we adapt this strategy using currency options. Now, let me just refresh your memory on why we have to cover an option when we sell it – the reason is simply that if we do not, we are exposing ourselves to unlimited risk as we have an obligation to deliver on the contract if we are exercised as the option writer ( or seller). So as in equity options, we NEVER sell naked puts or naked calls!

The implementation of the covered call strategy is very simple. Suppose we are mildly bullish on the pair and go long in the spot fx market, then instead of using a stop loss, we hedge some of our risk by “covering the position” by selling a call. From experience I have found the best option to use is the next available out of the money option, and with a strike price near our target. Now the further away the strike price, the greater the profit potential, but the greater the risk to the downside as the premium will be smaller.  I always work with monthly options, in exactly the same way as with the conventional covered call writing strategy.  So let’s look at some numbers and see how it all works.

  • Assume we are mildly bullish on the USD/CAD which we think will trend up slowly over the next few weeks. We do not want volatility in the market for this strategy.
  • The spot market is currently trading at parity – 1.oooo and we think that the pair may move 200 pips in the next 2-3 weeks.
  • We check the options for a strike price of 1.0200, and find that the next available OTM option is at 1.0180 with an expiry in three weeks. The premium is currently 50 pips.
  • We decide we like the trade and open 1 long spot fx contract and sell one short call option at 1.018, and collect a premium of 50 pips. The possible outcomes are as follows :
  1. The market rises, but never reaches the strike price. We keep the premium from the short call and the option expires worthless. We can write a further option on the open spot position, or close the spot position at a profit.
  2. The market rises very fast and passes our strike price, and we are exercised at expiry. We close out our spot fx position. We have forfeited profits above the strike price in return for a guaranteed premium in advance. Our profit would be the premium plus the number of pips the strike was out of the money when originally sold.
  3. The market falls – we have hedged our risk selling the call which has provided income to offset against any fall. Our breakeven here is 50 pips, lower than this and we are in loss on the trade. The option expires worthless but we still have our open spot position. We will need to decide what action to take which could be to close out, or wait for a pullback so we can write further calls.

Now the major difference between this covered call approach, and that of an equity option covered call is in the management of the trade. In general, with an equity option, we hold the stock and generally just wait until expiry, possibly rolling up and over into the next contract period. With currency options and hedging we have more decisions to make throughout the trade. For example in a long trade with a short call, if the underlying is going up, we may decide to close out some profit on the option, and sell another call with a strike closer to the new spot rate – this increase the hedge amount and provides further downside cover in the event of a pullback.

Now let’s look at the opposite of the covered call, the covered put. The covered put is exactly the same as the covered call, although in reverse! – in this case we are looking to go short in the spot market and to hedge the position by selling a put option. Again, I would look for the next available OTM option with 1 month or less to expiry. Remember as option sellers or writers, we always want time working on our side, so the shorter the time to expiry, the quicker that the time value element of the premium will waste away.
OK, that’s really all I wanted to explain about hedging using vanilla options. I hope the above have given you some ‘food for thought’ as to ways to improve or think about your trading in different ways. With the spot fx market it is very easy to just become seduced into a standard way of trading, with very little variation or thought, and I hope the above has at least made you stop and think – now before I wrap up, I would like to make a few comments about exotic options which have been left on the sidelines!

I will be very honest here and say straight away that I am a fan of the good old fashioned vanilla options. Having said that there are some advantages to using the exotics as a hedge, not least because of the limited risk/reward profile. Hedging a trade using an exotic option is perfectly valid, however personally I do not use them for several reasons. Firstly the premiums tend to be more expensive – being an OTC trade they cost more, and offer a worse return than a conventional option. In addition they are not priced by the market but by the broker or dealer. Finally I find it awkward to trade in an instrument that I cannot sell back to the market when I choose. I’m sure the market for exotic options will develop in the future, but at the moment I prefer to stay with the good old vanilla options, which themselves still have a long way to go in currency options trading.