Benefits of Options: Hedging

Today, the Bank of England (BoE) decided not to affect interest rates. They based this on their inflationary outlook of the economy. If interest rates had been raised (they weren’t), it would have been seen as good for the economy and bullish for the market. Then, the GBP may have become stronger against other currencies. 

This afternoon’s announcement from the BoE was pre-scheduled and the consensus was that the interest rate would stay at 0.5%. This is what the BoE did announce. But as we had seen from Australia earlier this week, when the Reserve Bank cut interest rates and devalued the Australian dollar (AUD), countries are looking to their long-term economic policy which can lead to unforeseen announcements and market movements.

As a company, investor, or trader, how can you protect yourself if you know an interest rate announcement is coming? You can hedge using option contracts. 

 

What is a hedge? 

A hedge is an investment position intended to offset potential losses which may be incurred by an adverse move in the market.

A good hedging tool is a vanilla option. You would use the option to neutralize your overall risk. For example, if you had an open long position in GBP/USD before the announcement, you could open a buy Put in GBP/USD. If the market rate falls, the Put will payout covering any loss from the long GBP/USD position. On the other hand, if you have an open short position in GBP/USD before the announcement, you could open a buy Call in GBP/USD. If the market rate rises, the Call will payout covering any loss from the short GBP/USD position. 

For more information on the payouts of Puts and Calls visit my lessons: The Call Option and The Put Option.

 

How to execute a hedge using options?

Most interest rate announcements are scheduled and if you want to protect your foreign-exchange investment with a hedge, it can be done. Just like taking out insurance against your investment, you can use options as insurance against a movement in the market shifting out of your favour. 

Let’s look at both scenarios – You hold either a buy or sell position with a profit and don’t want to close it before the announcement. You pay a premium to buy an option for both Calls and Puts. The premium of the option is the cost of the hedge.

You have an open buy GBP/USD position:

Assuming you held a long 100,000 GBP/USD spot position from 1.5000 and the current price is 1.5250, you would be in profit by $2500 (100,000 x 0.0250). To lock-in this profit without closing the trade, you could hedge by buying a Put with a strike of 1.5250 and amount of 100,000 as displayed in the diagram below.




If the market price continues to go up, your long 100,000 GBP/USD position will make $10 for every 1-point increase in the underlying market (100,000 x 0.0001 = $10). If the market falls, your GBP/USD position will lose $10 for every 1 point down, but the Put option will payout and cover (or hedge) any loss.

You have an open sell GBP/USD position: 

Assuming you held a sell 100,000 GBP/USD spot position from 1.5500 and the current price is 1.5250, you would be in profit by $2500 (100,000 x 0.0250). To lock-in this profit without closing the trade, you could hedge by buying a Call with a strike of 1.5250 and amount of 100,000 as displayed in the diagram below.




If the market price continues to go down, your short 100,000 GBP/USD position will make $10 for every 1-point decrease in the underlying market (100,000 x 0.0001 = $10). If the market rises, your GBP/USD position will lose $10 for every 1 point down, but the Call option will payout and cover (or hedge) any loss.