Hi there,
for university I have to create a Put Option to hedge a currency like the US-$. My main currency is the Euro, but it would work with every money. Could you help me there? I can only use “Buy” or “Sell” and Limit Orders. My group would get 6 of 6 points for this for our next strategy paper! And this would mean passing this game! 
Regards,
Andy
Create a put-option?
I don’t fully understand what you need to do. So you expect that the EUR will decrease (the thought alone! 
) and want to hedge against that? I would sell EURUSD, what means I’d exchange EUR for $s. But that leaves me with a risk when the EUR rises, which is not hedging.
Can you provide some more details?
Sure…
you could hedge the US$ with an opposite limit order. you have described this way to me!
But you could also hedge the $ (at 1,3 $/€ per example) with a put option. this allows you to sell the $ for a fixed price (per example 1,2 $/€). if the dollar goes down under the level of the put option (1,2$/€), then you sell it. in this example, you could also sell your $ right at the start. ok, stupid example ;)!
but I guess you know what a put option is! so the question is, how to create one with only market and limit orders. What is meant by this is, that you create an account, which has the currency like the $ and a Put option in it. One key element of an option is that you can use it if you want, but you don’t have to. I’m still a bit confused about the whole thing myself, but your hint with the normal hedging helped me a lot! Thank you for that!
Regards, Andy
You are talking about binary options… trading forex is different you open positions (Short or Long) and you stay there as long as you want too.
In order to trade in forex your have to open an account with a broker (forex.com, forexm…) most of the brokers let you open a demo so you can play with fake money.
Once you have your broker and your account is open, you can open a position, you can use stop loss and take profit is kind of similar from what you want, i am not sure but if you have a sell position opened you cant open a buy position at the same time. What can you do is Check your risk and reward, for example Lets say that i am going to open a short position on the usd/jpy for sunday, usd/jpy is @82.375 i will choose my volume considering what i am willing to risk and put a stop limit @ 82.421 and take profit on 81.710…
My hint??? Hahahaha… Okay, thank you for your lesson. I see that I have still a lot to learn. So will no longer waste your time with my noobishnish…
You cannot actually create a put using the spot forex market because you cannot recreate the optionality or necessarily the strict limit on the downside. The best you can do is to recreate approximately the profit/loss profile of the put. You would do that by going short the currency in question (meaning going long EUR/USD in this case) with a stop at the level representing a loss equal to the cost of the put.
Huh? What you mean? English is not my first language, so if I said something wrong, then sorry!
@rhody: I’m trading at a OANDA demo account. I hope there is any way. Hm…if anyone has an idea, please chime in!
Or are you sure, that there is no way, because you know it excactly?
As I said, you cannot create optionality using a spot market position. There is no way. The best you can do is attempt to closely approximate what the return would be for the option.
Rhody,
I don’t think that exactly copying an option is the purpose of the question, but to hedge with an option like structure, using market and limit orders. Hedging is to limit your position if a trade goes against you, you can do that by countering.
So I don’t fully understand what you are trying to say here Rhody. I am sure that Andy will also find it helpful if you provide some more explenation than just saying that you said that you cannot do something.
May I already thank you for your clear answer, so that we can learn from you?
IdeFX
His exact words were…
So forgive me if I’m talking about creating a put option. It doesn’t really matter what the reasoning is in any case.
Since options are the discussion here, I’m assuming the OP knows that a put option has a profitability distribution which rises to the left of the chart as the price of the underlying moves more negatively away from the strike price, but is flat after a given break-even point (the point below the strike price where the decline in the underlying matches the price of the option). It looks rather like a hockey still with the blade pointing to the right.
So how do we create a profitability distribution in the spot market which looks like the one for the option? We have to do something which replicates both parts of that distribution - the bit that rises to the left as the market falls and the bit that remains flat as the market rises. The former is replicated by a short position. In order to create the latter, we use a stop on that short to limit our losses.
One major problem, though. Once you stop out the short because of a positive move in the market, you’re done. That’s fine if the market keeps going higher, but if it turns back around and goes lower again you won’t be in position to benefit (to have the hedge in place in this example). There’s no way around this issue. You have to be short to benefit from the downside, but if you don’t have a stop then you are at risk of an unlimited downside on a market rally.
This is all because there’s no optionality in the spot market. What causes the hockey stick shape of the put option’s return distribution is the fact that you do not have to take a short from a position below the current market price (which is what would happen if you exercise the option when the market price is higher than the strike price), thus meaning the worst you can do is lose your premium. That means you can hold the put option for as long as you like (at least until it expires) and not have to worry about the market whipping you around, which isn’t the case with a spot position.
Sorry, I can’t resist…
It said to use a put option to HEDGE, using only BUY, SELL or LIMIT orders. As put options don’t exsist in FX and the University probably know that (as they ofcourse use your book for their courses) I thought, cause additional information was missing, that the excercise was used to create something similar in FX to hedge.
If it said: to use a nail to hang a frame on the wall using only glue. I guess you would continue discussing about what a nail is and why it will not work with this wall? I would read it as: okay how do I create some kind of fixture, like you have when using a nail, to hang a frame on a wall, using only glue.
Now you are also talking about the speculative use of options. Hedging is not ment for speculation but to mitigate your downside risk (in this case). So your profitability distribution doesn’t have a function as profitability is not the main purpose here.
You mentioned that you have to be short to benefit from the downside. Assuming hedging was the primairy goal and not making a profit, my answer was correct and you proof that…
Ahhh, this helps to relief some frustration that I am having now my wife is pregnant. Thank you for helping me out there Rhody, much appreciated and needed here. I am more than happy to return the favor if you have the same need…
Happy trading.
Whether you use a put option to hedge or as a speculative bet doesn’t matter. Either way, you are looking for the option to benefit from a downside move in the market, as you would if you were using a short position (such as short S&P 500 futures to hedge a stock portfolio). In the hedging case, that presumably offsets (at least partly) losses which would be experienced in an existing long position. As a result, the profitability distribution of the put (hedge) is absolutely the purpose here because you need to align it with your base position’s downside risk.
Thank you very much guys! I read all your post in the meantime. I believe rhody, that it’s impossible to build the option character of a put option. I don’t understand it completley, yet, which is because of my bad english! But I will read it again and again and if I still don’t understand, then I will ask again!
Well, we can either get 6 points by constructing a put option or make a good strategy paper for our next round. We only got 2,1,1 points for the first three rounds and need 2 in average, so we need 3,3 in the end or 2,4 or 4,2 … whatever :D.
Could maybe using a third currency help, rhody or is that crap?
Our problem is now, that we need to say excactly why we trade a special number of units. We got 100.000 Euros at the beginning and are still there, but we didn’t explain very well why we did this and that. We trade in the OANDA demo account, if you know that!? I got some questions now:
How do we put all that together to say how much we invest in one currency?
Thank you very much :)!
Regards,
Andy
Well it appears that you pushed me out of the way Rhody… Good luck with these challenging forex questions… This exceeds my level of expertise…