How Can You Hedge Currency Risk?

Recent events in the U.S. presidential election not only threaten the expected results on November 8 but also threaten the currency market. Hillary Clinton would be expected to uphold current international agreements even if she pushes for changes. Donald Trump is such an unknown that currency traders are concerned about what will happen if he gets into office. How can you hedge currency risk in such a situation?

Hedging Currency Risk

Last year we suggested the use of Forex options as a way to hedge currency risk.

There are two kinds of options that one can purchase or sell. These are calls and puts. A call gives the buyer the right to purchase one currency with another at a set price called the strike price. He has a base currency and purchases a call option on the reference currency. The buyer is under no obligation to do so and will only execute the options contract and make the purchase if it is profitable to do so. The seller of a call is, however, obligated to sell the base currency and purchase the reference currency if the buyer executes the options contract. The seller receives a premium for taking on this risk.

A put gives the buyer the right to sell one currency for another at set price called the strike price. He has a base currency and buys a put option that will allow him to sell the base currency and purchase the reference currency if doing so will make a profit or hedge against loss. The seller of a put contract is obligated to purchase the base currency with the reference currency when the buyer executes the contract. The seller receives a premium for taking on this risk.

The value of Forex options in situations like right now is that a trader can protect against loss and lock in potential gain while limiting risk in both up and down directions. A specific approach is to use a long straddle as described on our sister site, Options-Trading-Education.

A long straddle is buying both a call and a put on the same [Forex pair] with the same expiration date. In a long straddle options strategy the worst a trader can do is lose the cost the premiums paid for the call and the if the stock does not change price. However, this options trading strategy has potentially unlimited potential if the [Forex] price changes significantly.

How Likely Is a Trump Victory?

All of the fuss over the election results comes down to the fact that Trump is an unknown. He has a substantial skill set when it comes to attracting attention and getting votes in the Republican primaries. But he has not ever moved to the middle ground which is where traditionally American elections are won. The number of blue states and the swing states that are clearly in Clinton’s camp are probably enough to win the election. If that is the case then smart traders will take advantage of the current anxiety and bet with their options on a Clinton victory, namely a stronger dollar.