Hedging with options
According to Investorwords.com the definition of a hedge is “An investment made in order to reduce the risk of adverse price movements in a security, by taking an offsetting position in a related security, such as an option or a short sale”.
In plain English this means that if you have a position that you fear will move against you, you should employ a hedging strategy so that when it does move against you, you will not suffer a loss. In fact, a perfect hedge is one where you completely eliminate all risk, and also all chance of profit.
If you hold a long position in security A you are hoping that the value of A increases. However, you are afraid that A might fall in price thereby exposing you to a loss. To prevent this possibility you should take a long position in the opposite of A (let’s call it security Z).
Ideally A and Z are perfectly correlated so that a one point move in A corresponds to an opposing one point move in Z.
For example, suppose you have an investment in FXE which matches the performance of the Euro versus the US dollar. Every time the Euro moves up against the US$ FXE gains a point. To hedge against this position would be to take a half position in EUO which seeks to exceed the inverse of the Euro by 200% versus the US$. When the Euro falls by a half point, EUO gains by a point – theoretically at least. (There are some slight differences due to these funds having to pay their expenses and due to the fact that they attempt to match the daily performance and may be off by a fraction here or there, but these differences can add up over a long period of time).
Another possible way to hedge against a position in FXE is to buy a Leap put contract(s) so that when the Euro falls and FXE losses a point or two (or more) your put leap option will offset your loss. This is called a hedge and eliminates your risk. Keep in mind that you are not trying to profit on this trade; you are trying to get rid of risk.
Why would you do this? One possible example is perhaps you get paid in Euros but live in North America. In this scenario your purchasing power (your salary) would decrease every time the Euro drops in value (versus the US$).
Let’s suppose that you get paid $50,000 US per year in Euros. Today that would mean 40,600 Euros. (currency converter)
What happens if the Euro drops to parity with the US$? You would lose nearly 20% of your salary, not good. The thing to do therefore is to purchase a long term put contract on the FXE such that if the Euro falls to parity with the US$ your put contract will increase in value to $10,000.
When you buy in the money options contracts you can participate in a nearly dollar for dollar move in the underlying security. What this means is that the options contract will move in sync with the underlying security if the contract is deep in-the-money and also if there is plenty of time on your side.
Going back to our example: If you purchase 3 January 2012 put contracts with a strike price of 130 this will cost you approximately $14 or ($14 *100 shares per contract * 3 contracts) $4200. FXE currently trades around 122. If FXE were to move to 100 in the next 12 months you would have lost nearly $10,000 in purchasing power from your salary (remember the FXE reflects the value of the Euro, if it drops the Euro has also dropped).
Now let’s look at the value of your put contracts. With FXE at 100 your put contracts should sell for approximately $34 or ($34 * 100 shares per contract * 3 contracts) $10,200 which would offset your loss of purchasing power and be a nearly perfect hedge.
Your risk in this scenario would be if the Euro climbed versus the US$ and the value of your put contracts would fall. However your purchasing power would also have risen and therefore offset the loss in the investment.
My wife currently gets paid in GB Pounds and you can be rest assured that I will be running the numbers on the FXB (which is similar to FXE except in Pounds instead of Euros). Good luck and remember plan your trade and trade your plan.