The follow is a guest post by James. He’s has been managing an investment profile since the age of 17 and has been continuously successful with his choices for the past 13 years. His approach is based on finding unique opportunities while reducing fees to a minimum. Some of these trading strategies are very advanced, so I’d caution the against most people using it.
Whether you have property overseas or not, it will always be important to protect your portfolio from unexpected events. In today’s world especially, you just never exactly know how the national news or a statement by a reporter will affect the markets.
For that reason, hedging should be a part of your vocabulary as much as it should be in your portfolio. It’s one of those fancy words you’ll hear thrown around on CNBC or Bloomberg. You may even hear a finance guy using it in general conversation. He may be using it properly or just to sound intelligent, either way it’s a legitimate strategy that should be employed.
What are Options?
Hedging is a form of risk management. In most cases, this concept is used by utilizing options contracts. Before we even begin a hedging conversation, here’s a little background on what options are:
An option, per investopedia, “is a contract that gives the buyer the right, but not the obligation, to buy or sell an underlying asset a specific price on or before a certain date. An option, just like a stock or bond, is a security.”
For you beginners, options are come in two forms: Calls and Puts
Call: The option to buy a stock within a given period of time. You are betting on the stock to go up to a certain price.
Put: The option to sell a stock within a given period of time. You are betting on the stock to go down to a certain price.
Options allow you to reap the benefit of the movement of 100 shares, if the strike price is achieved. For example, you’ll see options that look like this: “$5 for a September 100 Call.”
The strike price (100 in this example) represents when the option can be exercised, until then it will be worthless.
Hedging is no more than an insurance policy on your investments. In its simplest form, it’s taking one risk to counterbalance another.
For more detailed information on how options work, see this article from CNBC.
How To Build a Hedging Strategy (For Beginners)
In our example, we will cover hedging a real estate property against currency risk.
Foreign Exchange Risk: The risk associated with the currency fluctuations
In doing research for this article, I came across a perfect example of such a transaction. Rather than recreate the wheel, I’ve modified an example found here from Londonpropertyguru.com. Full credit goes to them, I’ve just switched around some of the facts and circumstances to fit a model representing an American investing in overseas assets.
As a practical example, say you have a budget of €100,000 to buy a house in Germany and you are a US-based investor.
You would want to BUY EUR against USD at the bank to cover your purchase, and SELL EUR against USD, to cover your currency exposure for say the next six months.
The USD/EUR exchange rate at the time of purchase is 1.3220 and you have a time horizon of six months.
You go to your bank and, taking into account fees and commissions, get more or less $130,000 to go and buy your house in Germany.
At the same time, you would get a quote for a USD/EUR six-month exchange rate at say 1.3215 – 1.3225, meaning you could buy USD/EUR at six months at a level of 1.3225.
A trade of $10 USD a point indeed corresponds to your investment of $100,000 as currencies are quoted in 10,000th
That means that if the USD/EUR exchange rate moves up from 1.3225 to 1.3235 and you have bought for $10, you make $100.
Six months later you are happy to sell your house in Germany as it is now worth about $165,000, an excellent capital appreciation.
But the exchange rate between dollars and euros has moved, and you have to take that into account to calculate your actual return.
Had you not hedged the currency exposure, any move UP in the dollar versus the euro would have been detrimental to your overall return, any move DOWN would have been beneficial.
As far as which financial institutions to use regarding such transactions, look into companies like Moneycorp, OFX, or World First (chosen as top rated by MoneyTransferComparison.com) as they are easier for those less experienced. Additionally, they can give you guidance based on your needs.
Hedging is known as an advanced technique. Be sure to do your research and possibly consult a professional or mentor before taking the leap. Whether it’s books, blogs, or courses, do all that you can.
Remember, nobody will ever care about your money as much as you do.