Hedging and some examples

Wikipedia for more info: http://en.wikipedia.org/wiki/Foreign_exchange_option

Extract:

"In finance, a foreign exchange option (commonly shortened to just FX option) is a derivative where the owner has the right but not the obligation to exchange money denominated in one currency into another currency at a pre-agreed exchange rate on a specified date.

For example a USD/GBP FX option might be specified by a contract allowing the purchaser to exchange £1,000,000 into $2,000,000 on December 31st. In this case the pre-agreed exchange rate, or strike price, is 2USD/GBP or 0.5GBP/USD and the notional is £1,000,000. This type of contract may be called either a dollar call or a sterling put depending on the market convention. If the dollar is stronger than 0.5GBP/USD come December 31st (say at 0.55GBP/USD) then the option will be exercised, making a profit of (2 - 1/0.55)*1,000,000 = $181,818 or £100,000."

"Example
Suppose a United Kingdom manufacturing firm is expecting to be paid $100,000 for a piece of engineering equipment to be delivered in 90 days. If the exchange rate goes down over the next 90 days the UK firm will lose money, but if the rate goes up then the UK firm will make a profit. The UK firm can purchase an option (the right to sell part or all of their expected income for pounds sterling at a given rate near today's rate) to mitigate their risk of exchange rate fluctuation over the 90 days. Conversely another party may wish to have the reverse option for a similar reason. A market maker will buy and sell these options with the aim of making a profit while not incurring too much risk."




Hedging is the way to eliminate further loss. Like your example, if you didnt hedge your position and market goes worst, you loss wont be 50 pips but more. (Traders usual dont use SL if the hedge a position)

If the trader start with 2 position in different side (call hedging) in same time, they probably looking for ranging market, usual market start in asia session will push up and down looking for comfort zone between support and resistence. so they have both position close with profit.

Another trade is sometime you got wrong position but you dont wanna close it so you can hedge it by place another reverse position (the first thing you must know that the market wont be back in your direction in short time). So, the new position (second) will profit and the first will continue loss but your loss only spread between your positions.

The smart trader know WHEN they should close the second one and let the first one reduce the loss.

Example :
BUY EUR/USD at 1.2700 but market go lower until you aware that you have wrong position, you hedge it by SELL EUR/USD at 1.2650. Current market price is 1.2630 so you have -70 pips and +20 pips (net -50 pips)

You know market wont go lower than 1.2600 so you close SELL position in 1.2610 (+40 Pips) while the first one -90 pips. And you are right, market now directly up to 1.2670 and you close you position IF YOU THINK MARKET WONT GO HIGHER. So your loss -30 Pips

NETTO, You earn 40 pips from SELL position and loss 30 pips in BUY position, Netto, you still earn 10 pips (better than you close at -50 pips)

REMEMBER :
1. Every trader have their own style.
2. The method work only for trader that know HOW TO USE IT.