Yo yo yo yo, welcome to hedging for dummies. Now in an earlier tutorial we explained how to use the straddle strategy and we hinted at the fact that you shouldn’t confuse it with the hedging strategy as both have an essential feature in common (we also suggested you don’t go around straddling hedges as this can be hazardous to the health of your bum). Okay so… the main similarity these two strategies have is that both require you to place CALL and PUT options on the same asset. Now we explained how this works in the case of straddling so how exactly does it work for hedging?
Okay so hedging strategies are all about trying to get the most out of an uncertain market situation. In the straddle we saw that the market was looking like it was going one way, the trade was placed, then shortly after it began looking like it was going the other way, so it was necessary for a second option in the opposite direction to be placed. The main difference between straddling and hedging is that with hedging you place your trades quite close to one another. The reason you do this is that you are uncertain as to which way the market is going to go and you want to get a good strike price before the market actually starts to move. If you wait for the trend to begin to appear as in the example we presented for the straddle, then you’re already losing out in terms of the strike price.
So you’re trading on USD/JPY for the sake of argument, and you’re expecting NFP (Non Farm Payroll, the most tradable economic data release for USD), to be released in the next fifteen minutes. The forecast is that it will come in lower than expected, which is bad for the USD and likely to cause it to drop. You are monitoring its price but it is still ranging, the market has yet to take a position. We are now dangerously close to the release of the figures and movement is slight at best. What do you do? Well, you hedge, silly.
You place consecutive CALL and PUT trades before the market takes a position on the USD and get a reasonably good strike price. Then the data hits. Contrary to all the forecasts it actually comes in significantly higher than expected and the dollar takes off like a bottle-rocket. What do you do now? Well, you continue with your hedging strategy, silly (geez have you not even bothered to read the title of this tutorial or what!). Now that you know where the market is going on this occasion you double up on your CALL trade. This time you will not be getting the same strike price but it doesn’t matter. This second trade will counterbalance the loss of the initial PUT trade that is due to end out of the money now, and also bring you back some profits. If you are particularly balsy you can stake more on this second CALL trade (obviously you review such choices on a case by case basis, in this instance a bigger CALL makes sense). The trade expires and bang! You are in the money son.