How to Hedge Your Forex Positions With a Binary Option Investment

BinaryOptionsNow | Published on July 19, 2011 at 10:23 am

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Many forex traders experience situations in which they feel uncomfortable holding a forex position under some circumstances, usually due to a higher than normal risk of an unpredictable outcome. For example, substantial forex market volatility can accompany the release of major economic data, an important speech, or another event that has a significant impact on currency valuations.

More conservative traders will probably just opt to close out their existing position ahead of the risk event, if they have the opportunity to do so. This can be preferable to being surprised by the volatility that usually accompanies a market moving announcement as market makers quick adjust the exchange rate of a currency pair to discount the new information.

Nevertheless, this tactic involves extra transaction costs and can prevent a trader from ultimately seeing their position mature to a favorable outcome, especially if they cannot reestablish their position at a sufficiently interesting exchange rate once normal trading conditions return to the forex market.

 

Using Binary Options as Forex Position Hedges

An alternative strategy that has recently become available to retail forex traders involves hedging a portion of the risk involved in a forex trading position with a binary option.  Although a binary option cannot fully hedge a forex position since it only has a limited payout, it can provide a source of income that can help offset losses on the underlying forex position.

Specifically, traders holding long positions in a currency pair would usually purchase a binary put option to help offset some potential losses from a decline in the pair. On the other hand, traders holding short positions would tend to buy a binary call option as a partial hedge for their forex position against a rise in the pair.

 

Example of Hedging a Long EUR/USD Position Over the Non-Farm Payrolls Release

For example, consider the situation of a forex trader who wishes to hold a long EUR/USD position over the release of the key U.S. Non-Farm Payrolls or NFP data that usually comes out on the first Friday of each month. Although they are fairly confident they will profit on their position, they prudently use a stop loss sell order placed a big figure below the current market to protect their portfolio in case their view turns out to be wrong.

As a result, they are concerned about getting stopped out during a short term whipsaw exchange rate movement immediately after the release, only to ultimately be proven correct on the market’s direction in the longer term.

In this case, they could hedge their forex position by purchasing a one touch binary Euro put/U.S. Dollar call option, which is also sometimes simply called a down touch binary since it pays out immediately if the EUR/USD exchange rate market goes down to hit its strike price.

They would pay an upfront premium for the partial insurance the binary offers against an adverse exchange rate movement. Furthermore, they would probably also place a stop loss order with their online forex broker to acts as an additional backup plan just in case the market falls sharply.

 

Possible Outcome Analysis 

In the above example, if the market rises substantially after the NFP release, as the trader expects, they will profit handsomely on their long EUR/USD position, and will simply abandon their out of the money down binary option that they paid a small premium for.

Alternatively, if the market stays roughly the same after the NFP release, they might just close their forex position out to avoid running it over the upcoming weekend, and just hold onto the binary they purchased.

If the worst case happens and they are stopped out, the market will also have fallen below the strike price of their down touch binary option, which will then pay out to help offset losses incurred on the long EUR/USD position.

Furthermore, buying the binary as a hedge can also help mitigate any significant order slippage that may have occurred during the fast market that often follows the monthly NFP release, since the market can gap through an order level and leave the trader with a worse fill than they were expecting.

 

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