Using Box Options to Hedge Risk

What is a Forex Box Option?
A Forex Box Option is a custom designed area of price (X) and time (Y) that allows the trader to define where he or she thinks the price will go.

As shown below, the boxes are set in the future, highlighting where the trader expects the price at a certain point in time to hit. (The trader defines the option by drawing his area where he expects the price to fall.) Each Box option has a dynamic payout with a trader defined initial deposit. The dynamic payout is defined by the probability using technical analysis the currency pair is most likely to hit. A box defined right next to the current moving trend would have a low payout as opposed to a box defined opposing the current trend. Furthermore, the time frame in which the box is defined changes the dynamic payout. The shorter the time frame the higher the payout and vise versa. For instance, a box defined 10 hours from the current price in an area that opposes the trend would have a pay out of $1 to $3 over a box define 15 minutes from the current price along with the trend. In addition, there are two types of Boxes, hit or miss, for the purpose of hedging; we will only focus on hit boxes. Hit boxes are defined areas where the trader expects currency pair to hit.

 
(Oanda FxPlatform)

Hedging: Box options can be used as a hedging tool for open forex trading positions. One must keep in mind that hedging reduces the risk, as well decreases the possible payout. 

 In order to better understand the hedging process using box options, we will look at a real example:

From the chart above, we can infer that the trader bought 1 lot of EUR/USD at 1.3330 at a certain time.(shown by the red dot) When the trader decided to buy the lot, he or she would simultaneously buy a box option opposing the long spot position. (Buying a box option under the spot price) Buying this box option lowers the risk on the trade by hedging the risk. If the trader initially placed a stop loss of 10 pips, and the stop loss is hit, this would also mean the box option was hit resulting in a payment of $140 as well a loss of $100 due to the spot trade. (1 pip = $10)

In terms of box options, the trader would buy a box option that would give a payout larger than the loss incurred by the trade. If the trader were to lose $100, drop of 10 pips, the trader should look to purchase a box option that would give a payout greater than $100. As seen above, the maximum loss the trader can incur would be $60 rather than a $100 because the payout of the box, if it were hit, would be $140. Thus, $100- $40 (profit) = $60 net loss.

However, the pair has to increase by more than 10 pips in order for the trader to make any profit off the trade since the box option costs a $100.  Having this box option cuts the losses while also reducing the profits as the trade has to reach a certain amount of pips before the trader can break even. Finding the right box option can be a challenge since the initial amount is defined by the user and the pay out may differ depending on the area and the time frame.

I would only recommend this strategy for news trading and pairs with high volatility. Box Options are not recommended when trying to hedge medium and long term positions.

 
View of an actual box hit:

By Sumant Yerramilly