Portfolio hedging is usually done for very big portfolios from hedge funds, institutionals and pension funds that want to cut risks in investing at overseas equities such as Emerging Markets but it doesn’t necessarily need to be so. Today we have multiple instruments that can help an individual investor hedge his/hers portfolio no matter the size. The main reason to hedge currencies is to avoid capital loss in your base currency. As an example note that since February 26th 2020 the SP500 at the time of writing is 7.4% up while in EUR terms it’s down. What this means is that as a European investor even if you made good choices you would still lose money because USD had a massive drop vs EUR and that’s usually all you would care about, that’s the currency you buy apartments, groceries etc. Same goes for an American investing in Chinese equities or the Japanese Nikkei. Traditional theory says that over the long term currency diversification would suffice but that means that you actually have a balanced basket of world currencies in your portfolio and that’s hardly ever the case. Usually an American would have 90% in USD and then 10% in emerging markets or a European would have 60% of his portfolio in USD because of the stagnant European stock markets during the last two decades and the popularity of FAANG stocks. OK enough said, let’s see how someone can do this.
Of course we need a broker that gives us access to futures currency options markets. The biggest trading house is currently Globex. Interactive Brokers work well and also have nice visualization tools to see the graphs of when the options become profitable and actual numbers so you can make your own calculations. DeGiro also offers these services as well as the biggest brokers in USA (TD Ameritrade etc).
Different hedging tools
Ways to do it include futures and options on said futures, CFD options and shorting the currency pair. Let’s see all of them.
A future is a contract that enables the buyer or seller to buy or sell at a specified date and price the said asset (in this case either USD or EUR). That is a bit problematic for small players because these contracts trade at 125K minimums usually so if the expiry date comes you need to have that kind of money available. That also means that in order to hedge your portfolio you must have a big percentage of it available in cash form which kind of defeats the purpose since most investors want to actually have cash working for them either invested or available for new opportunities.
Futures Options are traditional options that you can read more about on Investopedia and we highly suggest doing that first because that’s a very complicated financial instrument. With options the major advantage is that you don’t need to have a big chunk of your capital that you want to protect available because options work inherently with (big) leverage. This is our preferred tool and you can see more about it on the example section.
Shorting the currency you hold most in your portfolio suffers from the same problem as the futures. If you want to hedge 300K in USD you need to have another 260K (approximation) available so you can hedge the dollar. Some Forex brokers will allow you leverage on this trade but the costs get out of hand fast and it’s not a long term solution. This is a good speculation when you want to actually short a foreign currency with a small part of your portfolio such as Brazilian, Turkish or other currencies in danger at turbulent times, but that’s not hedging risk.
The best planning can be done with futures and shorts because you know exactly the target prices and amounts. With options it’s more of a hit and miss. First you need to chose how far out of the money your strike price should be. Bibliography recommends 5% to 10% OTM puts work best for hedging. Usual practice is to buy them 6 months out so you don’t speculate much on short-term geopolitical problems and roll them over mid-to-end so that you don’t mess with all the Greeks and get best value for money. Options trading specifics are very complicated and our common thinking in Loft Financial is to not compete with trading powerhouses because they are sharks and they will eat you alive. Very few people in the world can determine what’s a good price for a certain currency future option and you are not one of them. Thus, it’s best to roll them over at some point mid-to-late when it’s either at or OTM. The reason for this is that options lose their time value when they are very deep ITM and thus you don’t gain much by rolling them over sooner.
Another big question is how much should you hedge for and what does this cover? You can play around and calculate when the options are ITM and profitable (after you deduct the premium) how much of the portfolio you can cover. A simple example would be:
Total portfolio value: 100K which is comprised of 70K USD and 30K EUR
Base currency: EUR
Current EUR/USD: 1.22
Strike price: 1.25
An option for a currency future of the EUR/USD pair is trading currently at $1700 for a 5% increase of the EUR to 1.25 and becomes profitable at 1.26 (because of the premium). Now we can pick a price difference from now. Let’s pick 1.29 that’s 5.7% up. That means that more or less our portfolio will take a hit for 3500. We can see with some online tools (your broker should provide this) that this option will yield a profit around 3000 at 1.29 so we could say that *most* of our USD risk will be covered. As the option goes deeper and deeper the hedge is bigger and starts to also be a profitable investment while between 1.26-1.29 it’s a big on the lower side covering only partial losses. If the option expires worthless that means that either USD was steady and you lost some capital for the premium or it went up so you gained overall.
Remember we are not trying to maximize profits but make the risk/reward profile better!
How much of your exposure should you hedge? Following the theory that you need to be diversified, if you hedge all your USD portfolio then you would be totally exposed to EUR. We believe a better strategy is to be diversified and leave some USD exposure as well as other currencies. One could hedge for example only half of the USD exposure for best diversification and least expenses on hedging.
They are complicated and a function of the difference between interest rates between the currency pairs. It’s also important what the current situation is and if there is market turbulence, recessions etc. There are quite a few ETFs that are hedged and we can see that they are usually at the 2.5%-3.5% mark. They will always get a better price than us due to volume and direct services from banks and clearing houses. This is not a trivial cost and can eat up profits long term so it’s a double edged sword. Currently options to hedge EUR/USD cost around 2% for 6 months.
- CME Group Managing Currency Hedging with Options
- Lund University European Investor Currency Hedging
- Interactive Brokers Mechanics of Overseas Trading
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Disclaimer: The information on this site is for informational purposes and isn’t financial advice. We cannot guarantee that you will have the same results as we have nor can we guarantee that the information shared here is appropriate for you. This is not financial advice and not given by professionals.