To hedge or not to hedge

options trading hedging techniques

The first articles have introduced options and their pricing dynamics. In this article we will look at how risks can be effectively hedged using options and what cost concern might arise. We will look at how options can be used in risk management, as opportunity seekers or to hedge away currency risk from a portfolio with assets spread across multiple currencies.

A corner stone in risk management of a trading portfolio is to keep a stop loss on a position in order to limit the loss from a wrong view on the market. This is a simple way to hedge some of the risk encountered by trading. However, the stop loss is not the perfect instrument it is sometimes made out to be. When a stop is hit a market order is automatically placed, but as the market is already moving the trader might sustain an additional loss from slippage. Furthermore, the stop loss might just be hit before the asset changes directions and moves in favor of the original trading stance. Both problems could be solved by hedging using an option instead. In the case of a long position the down side risk would be hedged by buying a put option. With the possibilities offered for tailoring the option in the OTC market the strike can be chosen to match the stop loss chosen for the trading strategy. The price of the put option would thus represent the price of the hedging slippage and the knock out of the stop loss. The reader of the last article will be aware of the fact that having a spot position and put position is the same as having a call option position, through the put-call parity. In the call option case the price for hedging slippage and knock out of the stop loss would be the time value of the option, as the intrinsic value (the payoff of the option if exercise immediately) is simply the price of the perfect stop loss. Considering whether to hedge thus boils down to a trade off between the price of the option which is certain and the possibility of slippage and knock out which is less certain.

A natural extension from the stop loss scenario is a buy/sell the break strategy, which also renders itself easier to do with options instead of stop orders. If a currency has been trading in a range one might expect a rapid move upon breaking this range. Using a stop order might get a very bad fill due to the potential runaway price spike, while buying the asset still in the range ties up capital if no breaks happens and even worse, if the asset breaks in the other direction, a possible loss.

This can be solved in the case of a buy the break strategy executed with a long call option placed at the top of the range. This hedges away the risk of a runaway price or false break out. Furthermore, one gets the opportunity to take part in a move while tying up less capital.

The price for this hedge is simply the premium which can then be weighed against the use of a stop order. If the price is deemed too expensive one might consider making a call spread. This is done by shorting a call further out of the money, thereby limiting the upside but lowering the premium. The payoffs can be seen in figure 1. The sell the break can be replicated in the same manner but by using put options instead.

options trading hedging techniques payoffs

FX options are not only for the FX minded traders or portfolio managers. A stock or bond investor easily gets involved in multiple markets thereby obtaining currency risk on the native value of his underlying portfolio. It is only natural and logical that the primary focus should be on the risk/return of the stock/bond itself. But this is not to say that focus on translation risk to the manger’s home currency should be ignored.  As recent events have showed the quick redraws from riskier emerging stock and bond markets can result in not only losses on these assets but also additional losses coming from the currency as well. An example could be an investor based in the Euro zone thus measuring his performance in Euros. If this investor is holding positions in Hungary he will automatically be expose to the performance of the EURHUF, whether he like it or not. If a crash occurred in the Hungarian market a flight to safety would probably follow leading to a rising EURHUF, opening up for a double loss for the investor. However, the currency risk could be hedge by holding a call position. The investor is thereby able to focus on his main investment strategy and obtaining a price for his FX exposure.

As with the break out trade above the investor might find the price for avoiding the loss too expensive, therefore, a traditional hedge is to buy a risk reversal that is still holding the long call but funding the premium by shorting a put. In this way, if the market stays stable both option expire out the money, if the emerging  currency starts to rise you would lose out on this appreciation, but due to the capital inflow that makes the put in the money this could potentially be made up for by the increase in stock or bond market. The risk reversal position can be seen in Figure 2.

options trading hedging techniques risk reversal

Even an investor that is not focusing on the emerging markets cannot be immune to swings of the FX market. As seen this year since equity markets have bottomed in February the EURUSD as rallied too. An Euro investor taken part in the opportunity presented at that time in the US market would have given up a substantial part of the gains in the currency market. Here a call option could secure the gains. Furthermore, given the current correlation in the market, a change of direction towards risk aversion again, might possibly sink not only the stock market but also the EURUSD. Here a put option on the EURUSD could protect against the currency risk.

This article has presented some simple strategies that can be constructed to hedge currency risk obtained through willingly or unwillingly trading in the FX markets. In the coming articles we will look further into how we can leverage opportunities by using options.

Steffen Gregersen