Posted by forex at 9:42 AM
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1. Open a discount brokerage account that supports online foreign exchange options trading, such as Gain Capital Securities Inc. or OptionsXpress Inc. In the United States, foreign exchange options are traded on the NASDAQ or the International Securities Exchange (ISE).
2. Determine what currency holding that you wish to hedge or protect. For example, if you are holding Japanese yen that you want to convert to U.S. dollars in the future, there is exposure to either the yen weakening or the U.S. dollar strengthening. Therefore, you will want to offset this by buying an option that would protect you financially in the scenarios of yen weakness or U.S. dollar strength. You only benefit if the yen strengthens versus the U.S. dollar.
3. Buy the appropriate foreign exchange option. In this example, you could buy call options on the U.S. dollar versus the Japanese yen, choosing a specific dated contract and a strike price. This gives you the right to buy dollars versus yen at or above the strike price. Since you are buying the call option, you need to pay the ask price, not the bid price and each currency option is quoted in hundreds. For example, an ask price of $1.75 means one option costs $175. If you were instead holding U.S. dollars that you wanted to convert to yen in the future, you would buy put options on the dollar versus the yen to protect yourself against a decline in the dollar and a stronger yen.
4. Monitor your trading position on a constant basis. The foreign exchange market can move significantly in a short amount of time, and therefore it is important to watch the progress of your trading positions. You can sell your option up to the expiration date if you want to get out of the hedged position.
5. Make a decision on your currency position by the exercise date of the option that you purchased. Based on the aforementioned example, if the U.S. dollar has strengthened versus the yen, you will want to exercise your call option as long as the currency pair is quoted at a higher rate versus the strike price. For example, if the U.S. dollar/Japanese yen is trading at 95 versus its strike price of 90. The gain that you make on exercising your options acts as an offset to the losses you would realize if you converted your yen to U.S. dollars at the prevailing, weaker yen rate. If, in contrast, the U.S. dollar has weakened and the yen has strengthened to 85, you would likely let the option expire and lose the premium you paid for the option. Yet, you would gain on your spot-foreign-exchange position because you could buy more U.S. dollars with the yen you are holding.