You speculate that the exchange rate of EURJPY will decline steeply in the next week and have the capital to sell 1,000,000 EURJPY on margin at the spot price of 105.00. Now you want to protect your position in case of a rise in the EURJPY rate.

Protection can be done in two ways
1) you can place a stop order, or
2) buy an option.

1) Placing a stop
Let’s say that you consider placing a stop, based on your analysis, at 106.00. Placing a stop order, you will, of course, limit the potential for loss to JPY 1,000,000 (around 9,434 EUR) if the stop (106) is traded, thereby closing your position.

2) Buy an option
The other way of protecting yourself from limitless downside in this scenario is with the purchase of a call option. Let’s say that you purchase a one-week call option with the same strike price as the stop-loss order (106.00) at a cost of JPY 300,000 (EUR 2,857). As the holder of this option, you will maintain the potential for unlimited profit because your spot position can stay open until the exercise date without having to worry about losing more than the option premium (JPY 300,000) and the (JPY 1,000,000) loss when the price is at 106.00. The option will protect any final price above that level. That’s because the call option gains value as the spot loses value. In other words, this option scenario can give you a staying power that is not possible with the use of stops. In any market, entering the market several times and hitting multiple stop losses is much more costly than establishing a more strategic options position. This is especially true in cases with high volatility.

The two strategies are shown in the graphic below. The thick blue line shows the profit/loss scenario for the hedged position. Keep in mind that in sideways markets, an option buying strategy can become costly because you are paying for time value that quickly erodes as the expiration date approaches.

Profit and Loss - Hedge

Another potential advantage of a hedging strategy is this: in the course of the option’s life, you may reassess your view of the market and wish to actually close the short spot position (even at a loss) in the expectation that the market is going the other way. In this scenario, you close the short position but keep the option, hoping that it will come in the money before expiration. For example, let’s say that after a few days, the spot price for EURJPY rises to 105.50 from the entry level of 105.00, and you have changed your mind about the direction of the market. Since you believe the rate will continue to rise, you close your spot position for a loss, but hang on to your option until the expiration. At any level above the break-even point of 106.3 you will begin to make a profit. And again, the option itself might be resold before expiration.