For example, at 10:00 you buy a Call-option on tool EUR/USD at 1.3600 strike price $ 100, with expiration at the end of the day (by 24:00).
The payment in case of a successful outcome of the event (the price to midnight will be higher than 1.3600 to any value) will be 170%, or $ 170, otherwise you will receive a refund in amount of 15% or $ 15. At 17:30 the price of EUR/USD reached 1.3700.
If you suspect that further progress can be changed in the opposite direction, it is now the time to buy a Put-option of the same value and the same period of validity for the new strike price (1.3570). Thus, we are putting the corridor along which, according to our assumption, the price will move. It is this action and will be called hedging one currency pair.
As a result, in this situation there are three possible outcomes at 24:00:
- The price for EUR/USD is lower than 1.3600 – first Call-option lost, the second – won. The total payout will be $185. You have invested only $200. As a result – a dead loss from two operations is $15 instead of $85.
- The price of EUR/USD is between 1.3600 and 1.3700 – both options appeared to be successful. The total payout will be $340. You have invested only $200. As a result – net profit of $140!
- The price of EUR/USD continued to grow and by the time of expiration it was higher than 1.3700 – first Call-option won, the second – lost. The total payout will be $185. You have invested only $200. As a result – a dead loss from two operations is $15 instead of $85.
You see that the two variants can cause damage, but only one of them brings profit. But let’s look at it otherwise. Before any transaction you should look at the behavior of the market, and not to make transactions at times when it is not worth the hassle. You should buy a second option if the price to total has reached a certain level of support / resistance or an abrupt change has been caused by some event or news outlet. In most cases, in such situation price adjustment in the opposite direction occurs. Therefore, it is more likely you will be able to make a profit, not a loss.
Also we can hedge foreign exchange risk by opening an option on an asset that differs from the main one, over which the insured transaction is made. There is a large number of assets which price movements happen synchronously or in opposite directions. In other words, if you bought a Call-Option on tool EUR/USD, it is possible to reduce the risks of buying a Put-Option USD/CHF, as these pairs move synchronously enough. There is also a number of cooperating / competing companies, which stock prices are also moving in one direction or in the opposite.
It turns out that making hedging risks, including financial ones, when it is required by the market or when you made a mistake, you can minimize the potential losses and significantly increase profits. A profit is almost 10 (!) times higher than the possible loss.
That’s all for now. Got any questions? Just ask the expert!